How Powerful is Compounding Interest Anyways?
“Compounding interest is the eight wonder of the world. He who understands it, earns it…He who doesn’t…pays it,” Einstein said.
Above is a graphical representation showing the power of compounding interest Einstein was talking about. Notice the principle or initial investment in blue is $1,000. The red wedge shows interest on the investment without reinvesting the gains (simple interest) i.e. the red wedge is saying after 20 years the initial investment of $1,000 would grow to $3,000 ($1,000 initial balance and $2,000 in interest earnings).
The green area represents the exponential power of compounding interest. At the end of the 20 year period the investment with compounding interest is worth over twice that of the simple interest ($7,400 compared to $3,000). Your compounding investment in year 20 is making 10% on $7,400 ($740) while the simple investment is making 10% on the same $1,000 ($100). That is how compounding interest becomes so powerful!!!
So, why am I telling you this? Seems like a no brainer to reinvest your gains, right? The truth of the matter is after a big gain in the stock market, real estate, etc. people have the urge to spend some of their gains, whether that be on a nice vacation or a new car. “I deserve to treat my self for making that smart investment,” you think. But with each withdrawal from the investment gains you are mitigating the full potential of compounding interest.
Some are totally oblivious to the reduction those “minor” withdrawals can have on an investment throughout its life. If you made a one time investment of $10,000 when you were 20, with a 7% return, then at age 80 you would have $574,464. But if you spent just 2.5% of your earnings each year on shoes and watches and crap, your ending balance would be $140,274 over the same period. That’s losing almost 77% of your potential return! Think about that next time you think those small purchases don’t matter.
The takeaway; before you begin withdrawing minor investment gains be sure you can stomach hindering those exceptional gains down the road. A dollar invested now is worth 5, 10 or 15 times that down the road. Ask yourself what’s more important, keeping up with the Joneses and showing off at the bar now or financial freedom later?
A way that’s helped me prevent withdrawals is to setup an account whether it be a Roth or traditional IRA, or a brokerage account, and act as though the account doesn’t exist. You should still re-balance the portfolio from time to time and use it in calculating net worth, but act as though it’s not on the table for spending. I understand there may be emergencies that arise when you have to withdraw from the account, but be smart in what you deem an emergency. Do your best to mitigate the withdrawals and remember the full potential of compounding interest!