The Magic of Compound Interest

A guest contribution from Miguel Herce on basic financial literacy

"Grow Your Money" by ccPixs.com is licensed under CC BY 2.0

I am delighted to hand over control of this week’s column to Miguel Herce, a great supporter of the Sharpen Your Axe project. Miguel has a PhD from the University of California, San Diego, and is a consultant in insurance economics. Spanish speakers can check out the website he runs with his brother here. Today’s column will teach us an important lesson on basic financial literacy for ordinary people - Rupert

By Miguel A. Herce

The son of a good friend recently asked me for some financial advice. This is what I told him:

I think you’d like it if I told you that $10,000 invested over 40 years at 5% per year would turn into $70,400. That’s about seven times the initial investment. And I’m certain you’d like to know that if the rate of return is 10% per year, instead of 5%, the ending balance would be $452,593, a bit more than 45 times the starting $10,000.

That’s all very nice, but nowadays, my friend’s son retorts, one can get upwards of 20% per year, even in investments as prosaic as an S&P 500 index fund. How would that work out? At 20% per year, over 40 years, I tell him, it would work out to $14,697,716, or about 1,470 times the initial $10,000. Now he’s listening!

This combination of time and interest is the basis of many financially secure retirement years, the paragon of financial virtue, and, in words often used among financial advisors, the “magic of compound interest.” And it really is magical, provided one does not get too carried away.

I’ll tell you more later because my good friend’s son is adamant that he can’t wait 40 years. Actually, he tells me that he can’t even wait a few months and that he’s sure that any cryptocurrency or any GameStop bet can give him as much or more, and far more quickly.

Indeed, wasn’t it the case that over a bit less than three months, between 28 January and 15 April 2021, bitcoin surged 108%, more than doubling its value from $30,432.55 to $63,314.01? And wasn’t it the case that in the first 27 days of January past, GameStop stock (GME) saw its value increase 18-fold from $18.84 to 347.51 per share? In-less-than-a-month!

Yes, we saw that; and some made a quick buck and some others didn’t live to tell the tale because bitcoin lost more than half its value in the subsequent three months. From 15 April to 20 July it fell from $63,314.01 to $29,807.35, and it took even less time for GME to lose even more: between 27 January and 19 February, it lost 88% of its value, falling from $347.51 to $40.59 per share.

In contrast, with the magic of compound interest, there is what I’ll refer to as the dark magic of unsound (investment) principles. The extreme volatility that cryptocurrencies or stocks like GME can experience at times is fed by events like Elon Musk’s mood, a blogger or two, herd behavior, occasional fraud (not absent, by the way, from conventional investments), and even a government crackdown. The pursuit of a quick buck always proceeds along a path strewn with financial bodies –about half and sometimes most of those who try. It is not worth it, except to people with voracious appetites for risk and/or delusional thinking.

But the magic of compound interest, as summarized in advice like “If you had invested $10,000 forty years ago at 10% per year, you would end up with $425,593 today” has its own bit of dark magic when one gets carried away by its promise. The reason is that the average retail saver/investor does not have a significant amount of money at the start of a 40-year investment horizon, generally in the early years of a working career.

Instead, the average retail investor is more likely to be able to save a bit every year for possibly less than 40 years so that, at the assumed 10% per year or at any other rate, compound interest will work on relatively small annual contributions, each benefiting from such compounding over an increasingly smaller number of years as they come in.

Suppose that my friend’s son is able to save $500 per year every year. This pattern will amount to a total of $20,000 over 40 years and will produce, assuming a 10% annual return, an ending balance of $243,426, amounting to 12.2 times the total contributions. Notice, in particular, that $20,000 saved over 40 years produce an ending balance which is less than the ending balance achieved when $10,000 are invested at the outset: $243,426, compared to $452,593.

Twelve times the total contributions is not bad, but it is a lot less than the 45 times in the unrealistic financial advice that one often sees. And, in any case, these numbers are based on 40 years and a generous 10% return per year. Assuming a 30-year period and a more realistic 5% per year return, these multiples are 4.3 for the $10,000 invested at the outset and 1.7 for the pattern of investing $500 every year. What kind of magic is this?

Acknowledging these facts, however, is the bit of realism that will make the magic of compound interest work for the retail investor. Returns matter, yes, they do, but there isn’t much one can do about what they will be over a long period of time, although seeking prudent investments is always important. But saving as much as possible, starting as early as possible, a bit every month, and ideally in a matching employer-sponsored plan, is the magic that counts. It gives compound interest the best chance to work its magic.

Sharpen Your Axe is a project to develop a community who want to think critically about the media, conspiracy theories and current affairs without getting conned by gurus selling fringe views. Please subscribe to get this content in your inbox every week. Shares on social media are appreciated! If this is the first post you have seen, I recommend starting with the critical-thinking rabbit hole.

[Updated on 10 March 2022] Opinions expressed on Substack and Twitter are those of Rupert Cocke as an individual and do not reflect the opinions or views of the organization where he works or its subsidiaries.