January 30, 2019
The Power of Compound Interest
Have you ever experienced a feeling of anger when you read in the newspapers that the common wealth in our society is going to be distributed increasingly unequally in the future?
Are you worried about the fact that it is unclear how the government will finance our pension when we retire at the age of 65 (or 67…or…).
Do you share the belief system of the majority of the society that you are the victimas you strongly believe that you have no control to change your financial situation unless you won the lottery or inherit a lot of money from your parents?
I personally encourage you to rewire your belief system as you are truly in control of your financial situation. Are you trulyawarethat with the current situation most people lose money on an annual basis as they simply leave it on their savings (=salaries) account. Well, a savings or a salaries account is something which everybody requires and there is nothing bad about it. You should simply be aware of the fact that you will lose around 2% of your average amount lying on the account. With, let’s say, EUR 10.000 this means that you lose EUR 200 yearly. Nowadays we do not earn interest on our savings anymore. Now, you would say, this does not generate a huge impact as I do not really pay the EUR 200 directly to the bank or elsewhere. But you have to understand that due to inflation (=money depreciation) you lose money in the long term. People with more money on their account are much more affected. This is why average or poor people get poorer in the long term.
The only way to counter fight this problem is simply by investing– this is what every wealthy person does. Did you know that since 1930 the stock market has generated an annual return of over 8% in average (EUR 800 with EUR 10.000)? Did you know that this is also the case when we only take the last 20 or 10 years into perspective? As you all know, we faced one of the biggest crisis in 2007/2008 where a lot of people lost money overnight. Now, you would probably say “I do not want to lose money”, but you always have to understand that as long as you stay in the market you do not lose moneyas you know that 8% or more can be expected in the long term. You must not sell in these rainy days! I do not want to go much deeper into this topic as it can be quite tricky and complex. However, since we now live in a digital world people like us have access to low-cost products (so called ETF’s) which replicate the movement of the stock market (remember: which generates 8% in the long term historically seen). ETF’s are exchange traded funds: This means that there is now the possibility to invest into a bucket (=fund) of 1.640 companies in the world (such as Apple, Microsoft, Amazon and many more) by starting with as little as EUR 50,- per month. By investing into a big bucket of individual stocks on a monthly basis over the next decades you 1) diversify your risk potential, 2) participate in the world’s economy development and 3) eliminate psychological factors (selling when stock market is going down).
The Power of Compound Interesthas once been described by Albert Einstein as the “eighth wonder of the world. He who understands it, earns it – he who doesn’t – pays it.” His words can be easily translated with a simple example: Imagine you invest EUR 250 (which is not “the world”) at the age of 25 and your goal is to retire at the age of 65. In total we are talking about 40 years of a monthly investment of EUR 250. Assuming that we can expect an 8% return in the long term the following happens: In 4 decades you invested exactly EUR 120.000. Sounds good. But what do you think happened by using the power of compounding? Your total wealth would be around EUR 811.000. EUR 690.000 are only interest you earned during the time. This is ridiculous, in my eyes, but real. The effect of compounding is strongly connected to one big factor: time. In the first couple of years you do not feel the effect very strong but as we are talking about an exponential function, which multiples with itself, the curve starts increasing dramatically.
I strongly believe that by putting aside EUR 250 and invest it into your “personal money machine” you can ensure financial stability when you retire. Most financial books recommend to save at least 10% of your net income. Imagine what would happen if you invest slightly more during your work life time?
This blog entry wants to raise awareness of the fact that everybody is in control of their finances. In the long term it is not about the fact how much you earn but rather what you do with 10% of your net income. I am quite sure that it is possible for everybody to save and invest at least 10% of their income. It can make a huge impact – in the long term.
Feel free to reach out to me if you want to know more about this topic.
Author: Alexander Wachter