Compound Returns

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:

Borrowing

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.

Investing

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.

InvestorYoshiZelda
Starting amount$10,000$15,000
Rate of return10%15%
Time horizon3015
Annual contribution$0$1,000

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.

Are you using compound returns to get rich or to get your bank richer? What is your plan like to become debt free, retire comfortably or to live with absolute financial freedom? Whatever it is, we are certain that we can add massive value to it.

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9 thoughts on “Compound Returns”

  1. My dad used to be a financial advisor and he always told me to start saving early. But he never put it this way. I am disappointed in myself for not listening to my dad but I’m still in my 30s so it’s not that late to start putting more money into my IRA and 401k.

  2. Nice and simple and also misleading because what if the Zelda makes more than 15% a year? Then she would catch up or maybe even do better than Yoshi.

    1. Yes, changing return rates would result in different results but that doesn’t make this specific instance misleading. According to many historical records, the average annual return for the S&P 500 (1928 through 2016) is approximately 10%. This is the rate we assumed for Yoshi. The point of the example is that even if Zelda beat the market (S&P 500) consistently (15% return rate) for 15 years, she still ends up with less than Yoshi. -Berk 😉

  3. What are your thoughts on bitcoin? Analysts say it’s gonna keep going up. Am I too late to join the party?

    1. Hi Allen – I think if you want to gamble with your money, why not go to the casino and play your favorite game? At least you’ll have a good time. What do you think?

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