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We’ve all heard the great phrase, “Rome wasn’t built in a day,” right? Welp, I’m here to inform you that this phrase applies to your wealth journey. In this post, we’ll discuss the power of compounding Investment returns (aka compound interest). You should know that compound interest is the most critical aspect of investing and building wealth. Understanding how compounding works is how most of the wealthiest individuals in the world have become wealthy.
Compounding interest is essentially the earning of interest on top of the interest you have already made on your initial investment. Another way of putting it is that the longer an investment sits and receives a consistent return, the more significant it will be as time passes.
If what I just stated above is confusing, don’t panic!
Compound Interest Explained
Personally, I think the best way to describe this is with a graph. Let’s look at the growth of a $10,000 investment over 30 years with a 7% rate of return. We will not be adding any money to the investment during this period.
In this example, the $10,000 we invested 30 years prior is now worth $81,165.
Not too bad, right? Considering we did nothing but park it there!
The blue portion of the graph shows the simple interest of what the investment would be after 30 years. Since 7% of $10,000 is $700, we multiply that by 30, and we get $21,000.
The orange portion shows how much money you’ve gained from interest growing on top of interest (or the 30 years 30-year period. That compound interest made up $50,165 of the investment!!! So a whopping 70% of the money made was made from compounding investment returns!!
This is the power of compounding investment returns! This is how you build true wealth over time!!!
To take advantage of compounding interest, here are some tips below.
Start Investing Early
If you start saving early enough, you will reap the benefits of compound interest throughout your life. This means that even though you won’t see much growth in your account balance right away, you will still earn interest on the money you put into savings accounts.
Time is money, and I can’t stress that enough. According to Healthline, the current life expectancy in the US is 76 years. An individual that invests $10,000 at the age of 25 would be better able to reap the benefits of an individual investing at 60. Invest early to take advantage of the compounding investment returns.
Focus on Diversification
It’s easy to focus too much on just one investment strategy. However, diversifying your investments across different asset classes (like stocks, bonds, real estate, etc.) can help protect against market volatility and reduce risks.
I used the return of 7% in the example at the beginning of this post for a specific reason. The reason is that since 1972 the average return of the S&P 500 before dividends was 7.5%. This average return is based on data provided by Robert Shiller (a Noble Prize Winning Economist).
The S&P 500 comprises approximately 500 large companies from different industries and sectors, allowing plenty of diversification. Without diversification, your returns can be all over the place due to the volatility of how companies perform depending on where we are in the economic cycle.
Be Patient
You should never expect to see immediate results when you start investing. Instead, focus on building wealth slowly over time. This will help you avoid getting discouraged and learn how to manage your investments effectively.
Wealth building is not a race! You don’t need to hand-pick the next Google, Facebook, Tesla, or Microsoft. Instead, invest and enjoy the journey. With my eyes, I have seen friends that have lost great deals of money trying to chase risky start-up companies or invest in the newest technology. However, the strategy of investing for the long term has been proven efficient for years!
Don’t Panic When Markets Crash
If you invest in stocks, bonds, real estate, or any other type of investment, there will be times when the market goes down. It’s normal to feel anxious during these periods, especially if you’re new to investing. However, don’t panic.
Panic selling your investments is one of the worst things you can do when investing long-term. When your investment portfolio is diversified amongst different asset classes and companies, the risk of losing your invested money decreases tremendously. If one company is performing poorly, another will likely be performing well! That is why investing in multiple companies is beneficial.
To sell your investments prematurely based on what you see today could hurt you in the long run. You could potentially lose out on tremendous gains when the financial markets recover. The effects of compounding returns can only work if you hold your investments!!!
