Hello Everyone! So here I am blogging again! Today I am going to talk about compounding interest again, and the nifty rule of 72. Most of you know that the main motive for investing is to make your money work for you, or to create "passive" income. But how much money can your money make you? Well, it can make you a lot, but it can also lose you a lot. But let's be optimists here, and talk about the positive side of compounding interest.
The Rule of 72: This is a quick and dirty way to calculate how long it will take for money to double given a specific interest rate. For example, if you have $10,000 and you invest it at a flat interest rate of 7% per year, it will take a little over 10 years for your money to double (72/7= 10.3). If your $10,000 is invested at a flat 9% it will take 8 years for you money to double (72/9= 8). Let's look at the power of doubling your money. If you are currently 25 years old and you invest $10,000 at 9% and never make another contribution, how much money will you have when you retire at age 65? In this situation you have a 40 year investment time horizon, and your money will double every 8, therefore your money will double 5 times. Consider how much you will have at each of the following ages:
Age Value
25 $10,000
33 $20,000
41 $40,000
49 $80,000
57 $160,000
65 $320,000
Wow! Not too bad considering you didn't have to lift a finger to make $310,000!
Now let's make this just a little more complicated. Let's assume that through out your life you are going to be able to add to your savings at a rate of $100 per month. Let's see what our table from above now looks like:
Age Value
25 $10,000
33 $34,580
41 $84,942
49 $188,130
57 $399,554
65 $832,745
Wow! Now we are talking! I think that most of use could spare a pair of jeans or a night out each month to be able to save just $100 per month! In fact, if you start with $10,000 and contribute just $140 per month and invest at 9%, you will have over $1 million dollars when you retire at age 65! Who would have thought it could be so easy to become a millionaire.
Of course there are some fundamental problems with our scenarios. First, if you can find any investment with a guaranteed 9% interest rate for the next 40 years, please let me know. Interest rates fluctuate, there are periods of very high interest rates such as the late 1980's, when you could invest in a 10 year treasury bond at 8-9%. In fact in 1981 the 10 year treasury bond was paying 15%! Today the 10 year treasury is just over 3%, this is barely enough to cover the inflation on your money. I use the treasury as an example because this is often used to represent a "risk-free" investment. Meaning that the only way that you would not get the said interest rate would be if the US government defaulted on the bond, which has never happened in US history.
Therefore, in order to find interest rates around 9% today you need to take considerably more risk with your money, such as invest it in the stock market. However there is no way you are going to get a guarantee on your interest rate in the stock market. I have seen people earn 51% in a year in the stock market, and I have seen people lose -40% in a year in the stock market. And don't forget about negative compound interest! If you lose 50% you have to make 100% to get back to even, and if you lose -62% you have to make 174% to get back to even. In general, people will assume that you can average about 7-8% per year when investing conservatively in the stoke market. However if you had been investing in the 1980s and 1990s you would have done much better than this, and if you had been investing in the 2000's you would have done much worse.
Cheers,
Bre
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