Time and Money – The Miracle of Compound Interest and Rate of Return

Once you have decided to start saving and investing for your future, understanding the concept and value of compound interest or rate of return will be helpful in your planning. For the sake of simplicity, I’ll use interest and rate of return as follows:

Interest

Interest means the amount of money earned on a savings account, savings Certificate of Deposit or other similar financial savings account. These are typically offered by banks and credit unions.

Rate of Return

Rate of Return means the money earned from mutual funds, stocks and bonds. This includes dividends and the increase or decrease of the value of the stocks, bonds or the share price of a mutual fund.

People at Work vs Money at Work

Relating to saving and investing, “People at Work” is an act of you setting aside money to save or invest for a future need. The money you set aside to save or invest originates from your earned income from work. Example: You decide to put $100 in a savings account and $300 into a mutual fund every month.

“Money at Work” is the money generated from the money you have already saved or invested. Example: The value of the mutual fund you own, excluding the continued deposits you made, increased $2,000 in value from dividends and the increase in the mutual fund’s share price.

Purposes for Savings Accounts and Investments

Everyone needs an emergency fund (rainy day fund) for unexpected events like a car repair, home repair, medical expense, or job loss. Most financial experts recommend a reserve fund equivalent to three months of your bring-home income. This can be in a savings account or simply kept in cash at home where it is readily available when when an emergency arises. If utilizing a savings account, it needs to be a separate account from any other savings accounts.

There may be a need to save money for a specific purpose like a vacation, wedding, big ticket purchase or whatever. A regular (passbook) savings account is ideal for such things. Passbook-like savings accounts fulfill the need to “save up” for a short period of time — usually under two years.

There are long-term reasons the accumulate money like retirement for yourself, higher education for your children and extended elderly healthcare (in-home or nursing home) for yourself and spouse. These events require large sums of money and cannot usually be met using savings accounts because they do not generate enough income from your accumulated money. Because if this, you need to invest (vs save) in mutual funds, stocks or bonds — or all three for diversity.

I recommend mutual funds because you don’t need to be a financial guru or an expert to benefit from the “market”. Specifically, I recommend a mutual fund indexed to the S&P 500.

While there is always some risk of loosing money in a certain years, the historical rates of annual return of return for the S&P 500 should ease your fears for current and future investment dollars. There are years that the rate of return will be lower than the average and there will be years when the rate of return will be higher than the average. The rate of return from one year to the next will vary … sometimes wildly.

S&P 500 Historical Annual Average Rate of Return With Dividends Reinvested

40-Year Average Annual Rate of Return: 9.395%
30-Year Average Annual Rate of Return: 9.435%
20-Year Average Annual Rate of Return: 9.261%
10-Year Average Annual Rate of Return: 9.203%

Source: DQYDJ

Potential Investment Results

Assumptions
Purpose of investment: Retirement (Roth IRA)
Money to open investment account: $100
Money to invest monthly: $300
Rate of Return: 9.2% (S&P 500 indexed mutual fund)
Dividends: Reinvested
Income Tax: None. No taxes are due during accumulation or withdrawal at retirement.
Inflation: 2% annually

10-Year Account Balance: $53,586.60
10-Year value after inflation: $48,547 (Future purchasing power in today’s dollars.)

20-Year Account Balance: $207,734
20-Year value after inflation: $138,685 (Future purchasing power in today’s dollars.)

30-Year Account Balance: $578,604
30-Year value after inflation: $315,620 (Future purchasing power in today’s dollars.)

40-Year Account Balance: $1,505,966
40-Year value after inflation: $671,210 (Future purchasing power in today’s dollars.)

As shown, inflation dramatically reduces the value (purchasing power) of your investment. What $100 will purchase today will purchase much less in the future. Any future planning that does not include the affects of inflation is a serious mistake.

As you can readily see from the data above, waiting 10 years to start will deprive you of $927,362! This clearly illustrates the time value of money. Compounding over time is a miracle. The more time you have to accumulate money — the better. So the moral of the story is to start investing while you are young. Each year you delay costs you dearly at the end.

If nothing else, start saving some money to make sure you have an emergency fund for unexpected events. Without an emergency fund, you will most likely need to finance (via a credit card or from a personal finance company) the amount of money needed for the unexpected event. This is never advantageous to you because of the their high interest rates. People who have saved and invested over the years understand this about interest: Interest is to be earned … not paid.

Published by W. M. Brown

I am a retired U.S. expat living in Ecuador. I was a business owner for 32 years before retiring in 2012.

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