Compound Interest: The Power of Compounding
What is Compound Interest?
There is a good chance that you have already heard the term compound interest before. And, likely, understand it to be a good thing. But as we continue to lay down the foundation, let’s understand what it is and what makes it a good thing. At its core it simply means making interest on your interest. Compound interest is the interest calculated on the initial principal (your initial investment) and the accumulated interest from previous periods. And it can significantly enhance the growth of your investments over time.
Below is an illustration of a $10,000 investment with an annual interest at 2% and at 3% to show how just a 1% difference can make a significant difference over time.
How Compounding Works
Imagine you invest $1,000 at an annual interest rate of 5%. After one year, you will have $1,050. In the second year, you will earn interest on $1,050, resulting in $1,102.50. This process continues, with your investment growing at an accelerating rate.
The Rule of 72
The Rule of 72 is a simple way to estimate how long it will take for an investment to double at a fixed annual rate of return. By dividing 72 by the annual interest rate, you can approximate the number of years needed to double your money. For example, if your investment grows at 8% per year, it will take about 9 years (72 / 8 = 9) to double.
As we have talked about, the over the past 40 years the S&P 500 has returned an average of 10%, meaning that if you just had your money invested in an index linked fund, your money would be doubling just about every seven year.
Importance of Starting Early
Both compound interest and the rule of 72 illustrate how and how why your greatest advantage to building wealth is time. The earlier you start investing, the more time your money has to grow through compounding. Even small contributions can grow significantly over time, making a substantial difference in your long-term financial goals. This highlights the importance of starting your investment journey as soon as possible.
Let’s look at two scenarios to illustrate this point:
Scenario A:
- Person A invests $6,500 per year from the age of 18 to 30 and then never invests again for a total investment of $78,000
- By the age of 55, Person A will have approximately $710,528 - a gain of $632,528
Scenario B:
- Person B invests $6,500 per year from the age of 30 to 55 for a total investment of $162,500
- By the age of 55, Person B will have approximately $446,397 - a gain of $283,897
That’s a difference of 122%!
Market Cycles: Understanding Economic Fluctuations
What are Market Cycles?
Market cycles refer to the natural fluctuation of the economy between periods of growth (expansion) and decline (recession). These cycles can impact the performance of your investments and understanding them can help you make informed decisions.
Phases of Market Cycles
1. Expansion: Characterized by increasing economic activity, rising employment, and growing consumer confidence. During this phase, stock prices generally rise.
There are a lot of reasons why stock prices rise during a period of expansion and most of them are driven by emotions. Basically, when there is growth, we are optimistic. Stock prices rise because of increased corporate profits, happy investors, lower unemployment, higher disposable income, increased business investments, favourable monetary policy, earnings growth, and mergers and acquisitions. When the market is in a time of expansion, we as people feel expansive.
2. Peak: The point at which economic growth reaches its highest point before starting to decline.There are many different factors that can contribute to a market reaching its peak and beginning to decline. But it mostly starts with interest rates. As interest rates rise, the cost of existing debt increases for businesses and consumers, reducing disposable income and profit margins. If you are curious about when a market expansion is going to reach its peak, just keep an eye on the interest rates.
3. Contraction: Marked by decreasing economic activity, rising unemployment, and falling consumer confidence. Stock prices often decline during this phase.
Stock prices often decline during this phase for the opposite reason that they rise during expansions. Emotions. There’s a negative feedback loop that erodes investor confidence and drives stock prices down as the economic outlook deteriorates.
4. Trough: The lowest point of the economic cycle before it begins to recover.A market recession reaches its trough and begins to rise when the economy begins to stabilize, investor confidence is restored. Lowering interest rates can be seen as a measure by the government to mitigate the downturn and support recovery, but this doesn’t always indicate that the tough has been reached.
Impact of Market Cycles on Investments
Again think back to our conversation on diversification. Market cycles are another reason why you want to diversify your investment vehicles. Different types of investments perform better at various stages of the market cycle. For example, stocks tend to perform well during expansion phases, while bonds may offer stability during contractions. When you re-balance your portfolio, you want to understand where the economy is in the market cycle so you can adjust your investment strategy to take advantage of these fluctuations.
Empower Your Wealth: Become Your Own Financial Investment Manager is a 20 part series that teaches readers how to self-manage their investments. It covers basics to advanced strategies, emphasizing the importance of financial independence, diversification, risk management, and technology.