Compound returns is the cumulative effect of a series of gains or losses that take place on an original amount. It is one of the most awesome and shocking features of mathematics. Imagine a chess board that is 8×8 with 64 squares. If we put $1 on the first square and increase it by 10% for every other square, do you know how much money we end up with at the 64th square? You might be tempted to say that it is somewhere around $64, $100 or perhaps $200. The answer is $405!
Compound returns can make you or break you in two ways:
Let’s say that you have a credit card balance of $10,000 with 16% APR and you are making the minimum payment of $250 a month. Without the interest, it takes 40 months to pay off the balance ($10,000 / $250 = 40). However, if you are making minimum payments only, it’ll take you 58 months and by the time you are done, you’ll end up paying an additional $4,386 on interest. This is the brake case for you and the make case for the credit card company.
Let’s say that you have $50,000 in your retirement portfolio and you have 20 years till retirement. If your portfolio grows by 5% every year – which is conservative – at the end of the 20th year, you’ll end up with $132,664. This would be the make case for you.
The true power of compound returns is the number of repetitions (years), not the rate of return. Because of this, you want to begin investing as early as possible. Check out these two cases:
Yoshi is a frugal guy who began investing early in his career. He started with $10,000 and invested that money for 30 years at a 10% rate of return. Zelda, on the other hand, lived large and always knew that she could catch up later. She waited for many years before she began investing. She started out with $15,000 and she invested for 15 years. She picked better stocks than Yoshi and she received 15% return annually. To catch up, she added an additional $1,000 to her portfolio every year.
|Rate of return||10%||15%|
How did they fare? Yoshi ended up with $158,631 at the end of his investing journey, where Zelda only had $122,716. Note that Yoshi only put $10,000 in the stock market but Zelda put a total of $30,000 instead. As you can see, having more money to invest and having a better rate of return did not help Zelda.
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