What if I told you that you could double your money every 9 years without having to lift a finger? You’d probably either ask me what type of scam I’m running or where you can sign up. So, what is this miracle opportunity I’m offering? It’s what we here call the Miracle of Compound Interest. Compound interest is when you get interest on your principal and the previous interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
So, for example if you make 10% compound interest on $1000 after the first year you have $1100 ($1000 + $100). At the end of the next year you have $1210 ($1100 + $110). Continue this year after year and you get the following:
In the example diagram above you can see that after 20 years you’d have more than 7x (that’s right, seven times) as much money as if you’d had either just kept your money in a safety deposit box or had put it in an investment that doesn’t have compounding interest, like a treasury note.
Where can I sign up?
This is where it gets a bit tricky. Unfortunately these days there aren’t any viable investments where you can get a 10% return on your investment year over year. If an investment is offering 10% you need to understand the risk profile.
One place you can get relatively good returns is in the US stock market. The S&P 500, the index of the 500 largest US-based companies has historically returned an average annual return of 7-8% year over year. However, as everyone should know, investments in the stock market can lose money. For example, just in the last 3 months of 2018 the stock market lost about 10%, erasing the gains for the entire year. During the Financial Crisis of 2008-2009 the market lost almost 50% of its value. Since then it has rallied tremendously and is back on course to meet the long term average of 7-8% gains.
You need to have a long time horizon
If you might need your money in the next year or two putting your money into the stock market is probably not the best strategy. You may end up 15% up, but you may also end up 15% down, so if you can’t afford to risk losing money, it is better to put it in a safer investment like a high-yielding checking account (check our our banking recommendations).
However, if you can put the money in and leave it for several years, you have a good chance to let it grow on it’s own, over time, creating wealth for you and putting you on the path to FIRE. Even if you had put your money into the market at it’s 2007 peak and done nothing, you’d still have doubled it between then and now, excluding dividends. With dividend re-investment you’d have nearly tripled your investment, and that is with one of the worst crashes in history.
Taking advantage of compounding interest is a way to maximize your long-term wealth, but finding investments that offer attractive rates (over 5-6%) will involve taking some risk, which means you need to have a long investing time horizon. You can’t afford to sell out at the bottom only to miss the rally – you need to hold in there and remember this is a long-term commitment.
If you can do this you’ll be setting yourself up to retire in style and enjoy the benefits of your patience.
Here at Caveman Cash we believe that everyone can achieve personal financial independence, and we’re dedicated to helping you along this journey. If you haven’t already done so, please consider signing-up for our newsletter which will bring some great deals to your inbox every week and let you know when we are running our Financial Freedom courses.
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