$10,000 invested in the US Stock Market in 1975 is worth $2,209,000 today. This result comes from an 11.9% annual return compounded over 48 years.
Compound growth can help you transform your income into wealth.
Small changes in saving and investing today can produce massive changes in future wealth. Conversely, debt can compound, putting your money to work against you and diminishing future wealth.
Compound Growth and The $415,000 Honda Civic
Oscar is my 2010 Civic. By age 60, I expect my decision to drive Oscar for seven years to produce $415,000 in wealth.
This drastic number comes from compound growth. Here is how this works.
Back in 2016, I bought Oscar used for $6,000 cash. Since then, Oscar has had an equivalent car payment of $33/month over the past seven years. The average Canadian lease payment is $456/month. I have saved $423/month by driving Oscar.
This $423/month has been invested in stock index funds, receiving an annual compounded return of 7%.
At the time of writing (February 2023), Oscar has produced $38,000 of wealth. My seven years of driving Oscar have put compounding to work.
But it gets better.
Left untouched, I expect this $38,000 to grow to $415,000 by age 60, at an 8% return.
The process was pretty painless, except for one ego bruise. An 18-year-old kid told me my car was $#!t. My ego has fully recovered since this event.
Compound Growth is Non-Intuitive
The mind finds linear relationships intuitive, like simple interest. But compound interest is non-linear and, therefore, non-intuitive.
This causes two main biases:
(1) The mind overestimates what compound growth can do in the short term (1-5 years). The lack of quick results can be disappointing.
(2) The mind underestimates the power of compound growth in the long term, say 10+ years.
Linear Thinking: Simple Interest
It is useful to think about earning 10% on $1,000.
Using simple interest, you will earn $100/year on your $1,000. Over ten years, you’ll earn ($100/year)x(10 years) = $1,000 of interest. At year 10, you have $2,000.
Simple interest is easy to understand. It is intuitive, resulting in the white bars in the plot below. But investing doesn’t work like this.
The Exponential Reality
With investment growth, you don’t just earn interest on the original investment. Instead, you earn interest on the interest. This process repeats, resulting in a non-intuitive snowball effect.
Take a look at the chart below. It shows compound growth of $1,000 with a 10% interest rate.
Like simple interest, you get $100 of interest in year 1. But now things change. start year two with $1,100. In year two, you earn 10% of $1,100, equating to $110 in returns.
You earned an extra $10 in year two relative to the simple interest case.
In year two, you earn interest on interest. Remember that $100 of interest earned in year one. That $100 earns $10 of interest in year two.
Study the table below to see how the snowball effect is amplified over the years.
Compounding & Time: The Advantage of Investing While Young
The compounding effect is slow at first, but it has a massive impact over time. Just take a peek at the chart below that compares simple interest to compound interest.
Compounding starts slow. But exponential growth hits hard after a few decades.
Consider two humans, Amy and Paul. Both have the same annual income from age 20 to age 60.
Paul only wears designer clothes, drives a leased 3-Series, and hosts an extravagant wedding. These decisions cause Paul to delay investing $1,000/month until age 35.
Amy has a different lifestyle. She wears quality clothing but avoids luxury. In addition, she uses sinking funds to save for upcoming expenses. Amy pays in the pull, in cash, for her used economy car and her cost-effective wedding.
These decisions enable Amy to save and invest $1,000 monthly starting at age 20.
At age 60, Amy has $3,500,000, and Paul has $960,000.The only difference is that Paul starts 15 years later.
Compound Growth, Opportunity Cost and Good Decisions
A decision requires that you select between two or more alternatives. I don’t think it is possible to make a good decision without understanding the alternatives.
What is the alternative to spending money?
Investing for compound growth is one alternative to non-essential spending. Consider the decision to buy a $50,000 boat. By purchasing the boat, you lose the opportunity to grow money to $200,000 in 20 years and $500,000 in 30 years (at an 8% return).
It’s not “bad” to buy a boat. But an informed decision is not possible without understanding the alternative to invest for compound growth.
Some people may find that the boat will provide more value today than $200,000 will in 20 years. This would be an informed decision.
Compounding: It Can Work For You, Or Against You
Consider a world where minimum debt payments do not exist. Jake makes up this world to prove a point.
In this world, Fred has $10,000 on a credit card with a 20% interest rate.
At the end of year 1, Fred owes $2,000 of interest. Now Fred’s debt is $12,000 ($10,000 + $2,000). In year two, you must pay 20% interest on $12,000. That’s $2,400.
In this example, you are paying interest on interest. Money is working against you.
Compounding Transforms Income Into Wealth
Media and society often confuse income with wealth. Income is not wealth.
Instead, wealth is net-worth. It is what you own minus what you owe.
Many high-earners are balance-sheet-poor (low net worth) because they spend their income on depreciating assets (vehicles, designer clothes and electronics) that look nice.
There is nothing left to put toward assets that undergo compound growth! This is not how we roll at Wealthy Corner.
Studies of millionaires show that most self-made millionaires are frugal. They are disciplined in managing expenses so that they can use their income to buy assets that undergo compound growth.
To show how compounding amplifies the effects of decisions, consider these three alternate uses for $100,000.
Consider George who makes $90,000/year and drives a 10-year-old Civic. George uses his income to buy stocks and bonds that undergo compound growth.
Now consider Fred, who also makes $90,000/year. Fred goes on lavish vacations, leases a BMW 328I and owns an expensive condo.
According to Instagram, Fred looks wealthy, and George looks unimpressive. But the reality is different.
George has $250,000 in stocks and bonds. Fred has a negative net worth (more debt than assets) and is enslaved to his lenders.
Self-Discipline and The Compound Effect
Self-discipline, in my mind, is best defined as the capacity to delay immediate gratification.
The compound effect rewards those with self-discipline, and it punishes those who pull gratification from the future (consumer debt).
By investing, you delay today’s spending (gratification) to buy assets that undergo compound growth.
By taking on debt, you pull gratification from the future to increase spending today.
In my assessment, taking on debt is the exact opposite of self-discipline. I’m unsure of what word describes this best. Perhaps hedonism?
Compounding Intensifies Wealth Inequality
The compound effect transforms small changes today into tremendous changes tomorrow. Two people who earn the same income can have massive changes in end-wealth.
Such is the nature of compound growth. It produces massive inequalities in wealth. This is characteristic of any Pareto distributed systems – small changes in inputs can produce large changes in outputs.
The media (and society) often confuse income inequality with wealth inequality. Income inequality is much smaller than wealth inequality.
Compound Growth and Individual Ownership
Compound growth can magnify small lifestyle changes to produce significant changes in long-term wealth. These small changes are often in the control of the individual – you.
The good news is that you control your decisions: compound growth provides and incentive for individual ownership and responsibility.
I don’t think the world is 100% fair. I don’t focus on this, because energy devoted to things outside of your control is energy not devoted to things in your control.
And your saving and investing habits are in your control (unless you can’t afford essentials). Financial education is available to anyone with internet access.
If you are reading this, you can access the earnings power of global businesses (compound growth) with zero-commission brokerages and low-cost index funds.
Individual ownership and self-discipline are critical to benefit from compounding. This is especially true today, as it’s never been harder to control spending given social media, targeted Ads, tap payment system and easily accessible debt.
Conclusion
- Income is not wealth. to grow wealth, income must be used to buy assets that undergo compound growth (stocks, bonds, rental real estate).
- Taking on debt puts compounding to work against you. Investing puts compounding to work for you.
- Compound growth magnifies the effects of small changes today, increasing the demands on self-discipline and individual ownership.
- Money is not the only thing that compounds. Your habits and knowledge also compound.