Part 6: The Greatest Financial Secret: Compound Interest

[Part 6 of 12 in a series on How to Turn Your Financial Goals into Reality.]

"Investing genius consists of one part patience and one part compound interest." This is a quote from one of the world’s great investors, the late Philip Carret, who founded of the Pioneer Fund in 1928.

Carret’s comment epitomizes the very essence as to why so few people are successful at making their savings grow through investing. Many people lack the patience to be successful and even fewer recognize the importance of compound interest as an essential tool for financial achievement.

Why is compound interest so vital to growing our savings? It is because compound interest is interest paid, not only on the initial principal (the money we have saved), but also on the accumulated interest of prior periods. In other words, over time we earn interest on interest, thus explaining the multiplying effect of compound interest.

The Remarkable Nature of Compound Interest

Here’s an example:
$100 compounding at 5% over 20 years grows to $265.
(OK, so far this is not so remarkable, but please read on.)

Investing $100 each month compounding at 5% over 20 years grows to $41,000. This illustration demonstrates the powerful combination of an ongoing savings program and compound interest.

The power of compound interest accelerates when applied beyond 20 years. For instance, take the previous example and extend it to 30 years. Now the total amount grows to $82,000. That’s 100% more value in only 50% more time—THAT’S compound interest at work! After 40 years—lookout! The total soars to $151,000. Are you 20 to 30 years old? Listen up! This is a simple key to future wealth. Just imagine the results if you could invest more than $100 per month!

Strategies for Harnessing Compound Interest

So what are the best savings and investment vehicles to take advantage of compound interest?

Regular bank savings accounts are fine for maintaining money close at hand for emergencies, but due to low interest rates and the fact that the interest earned in bank saving accounts is taxable, the total accumulation over time is severely eroded.

A better choice would be the higher interest rates paid on money market accounts or certificates of deposit available from various financial companies. These interest-bearing products are designed to preserve principle while providing a reasonable return in light of the prevailing financial conditions.

Fixed annuities normally pay very competitive interest rates. In addition, annuities shelter your earnings from taxes, preserving more of the account value. Fixed annuities are products of insurance companies, which are well-known for their ability to protect investors’ capital over long periods of time.

Under the proper conditions, a diversified portfolio of dividend-paying stocks and bonds can also take advantage of the wonder of compound interest. Whenever possible, utilize tax-deferred accounts, such as a 401(k) or IRA for stock and bond investments for best results. It is important to remember that under certain economic conditions, stocks and bonds can lose value. However, over longer periods of time, especially 20 years or more, both stocks and bonds normally increase more than cash savings accounts and generally provide greater buying power in the future once inflation has been considered.

In Summary

Albert Einstein referred to it as the eighth wonder of the world. Ben Franklin wrote: “’Tis the stone that will turn all your lead into gold.” Venerable money manager, Joseph Rosenberg, called it: “The most important thing in investing.” All these great and scholarly men were singing the praises of compound interest.

Schemes to get rich quick come and go, often leaving the investor on the losing end of the deal. But the strategy of harnessing the power of compound interest in a long-term investment plan has stood the test of time and will continue to reward those that remain patient.

Dale A. True, Registered Investment Adviser
True Financial Strategies, LLC
September 2008

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