skip to Main Content

Spectacular Growth Over Time With Compounding Interest

Last Updated on January 2, 2021 by Mr. FightToFIRE

For those looking to invest for the first time, it’s important to first look at what happens if you put your money in a regular savings account. A lot of people do this in fear of losing all their money. However, due to Inflation, most of the interest you earn is lost.

Inflation sits on an average of 3% per year since 1900. It’s a silent killer that vaporizes your savings over the long term. To make it more concrete, anyone who saves 10.000 EUR over 5 years sees his buying power diminish to 8500 EUR over those years. It’s not so bad because you save new money every year.

However, fifty years later, only a small smoldering heap of cash remains, you accumulate a whopping minus 66 percent (see table). Of course, you don’t just keep it under your mattress, so thanks to the interest you get from your bank, but it’s insufficient to counter the inflation.

Stocks is the way to go

In the past 150 years, bonds were able to compensate for inflation and even provide a small extra of about 2.3%.

If you want to see bigger returns and are able to invest long term, must look at stocks. This type of investment provided an average real return of 6% over the past 150 years (this includes reinvestment of dividends).

6% might not seem like much, but when converted to ‘nominal’ yields, meaning return including inflation, this gives you 9% per year.

Inflation: the 8th wonder of the world

Those who think 6% isn’t much, might change their mind once they realize this return can repeat itself, year after year. Over the long term, this amasses to a massive amount Albert Einstein didn’t call inflation the 8th world wonder for nothing.

This makes it possible to turn even a small starting amount into a fortune. The condition: an early start and/or a high return. Combining both is the perfect storm.

If a student would invest the money he earns from holiday jobs in shares instead of consuming it, he wouldn’t have to save much for the rest of his life (see table). With an average real return of 6% per year, he increases his purchasing15.7 times. His 10,000 euros has become 157,213 EUR. If this smart student manages to achieve a 7.25% return, his purchasing power will increase to more than 330,000 euros.
Small annual differences give explosive differences due to the miracle of compound interest. Hence also the big difference with the final amount when he invests in bonds.

How much is 10,000 worth?

Compounding interest – the 8th wonder of the world.
A student (16 y/o) earns 2,000 euro per year over the summer for 5 years and starts from scratch.

At the age of Invested in stocks (6% yearly real return) Invested in bonds (2.5% yearly real return) Saved under a mattress (yearly inflation of 2%)
21 (after 5 years) 11,951 EUR 10,775 EUR 8,572.11 EUR
30 (after 14 years) 18,204 EUR 13,457 EUR 7,146,96 EUR
50 (after 34 years) 58,383 EUR 22,050 EUR 4,771,37 EUR
67 (after 51 years) 157,213 EUR 33,552 EUR 3,384,44 EUR

Of course, that 6% is an average over a very long period of time. It’s very difficult to keep cool during an economic crisis and not sell. Many investors have not forgotten 2008, one of the worst years on the stock market ever. Even the major stock exchanges suddenly dropped by more than 40%. More recently, we also have the Coronacrisis of 2020.
On the other hand, however, there were also years in which prices climbed by 30 or more percent. A weak period is often followed by an episode of high returns.

Conclusion

So even if you enter the stock market at a very bad time, you can end up with a profit – provided you are patient. Anyone who bought shares in the year 2000, at the top of the Internet bubble, and then collapsed with the financial crisis in 2008, saw their capital halved twice. Today, however, even that unlucky man is making a profit.

Globally, since then, the major stock exchanges in 23 countries have offered profits of around 80% (in nominal terms). Admittedly, over those 16 years, that does not give a 6% real yield per year. But even those unlucky ones have seen their purchasing power increase by more than 2 percent a year. A savings account does not yield that.

Remember!

  • Compounding interest works best the longer you stay in the market.
  • Stocks easily beat inflation; inflation eats away your money if you do nothing.

I'm a developer for a major financial institution in Belgium that is present in over 40 countries. I have over 8 years of working experience in the development of customer applications focussing on all aspects of banking. This helped me gain a deep understanding of the inner workings of a commercial bank. All of this experience in both banking and life culminates in this blog about personal finance and my fight towards FIRE.

Start to invest
1. Spectacular Growth Over Time With Compounding Interest
2. Owning stock in the good and the bad times
0 0 votes
Article Rating
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments
Back To Top
×Close search
Search
0
Would love your thoughts, please comment.x
()
x