One of the most important things to learn about when it comes to investing, or the even broader category of building wealth, is the appreciation of the raw power that exponential compounding holds.
The most powerful force in the universe is compound interest.
Most income streams that people are familiar with are linear, as in, they grow at a linear pace. In a unit that I’ve worked in, the manager with 40 years of experience made about twice as much money as one of the entry level employees fresh of out college. So 40 years later, and with ten times the experience, he gets twice the pay as someone just starting out. Neither salary is bad, but I’m sure you can see the disparity I’m talking about. The amount of personal growth he’s had over the years has only managed to double his earning power. This isn’t necessarily a bad thing because he likes what he does, but when it comes to making money, there has to be a better way. Luckily, there is.
When you work for a paycheck, the amount of money you make is limited. The manager’s time is valuable, but only to a finite extent, because he can only do one thing at a time. He has 8 hours in a day to do things, and so 40 years of experience later, he’s still limited, even if he’s overseeing other people and making higher level decisions.
The money that he invests from his job, however, compounds. It does not grow linearly, but instead grows exponentially, which means that each year it grows as a percentage of the previous year, and so grows by a larger amount each year. By starting now, you can build up an exponentially growing stream of income and wealth.
The math of compounding
If I put $10,000 into an account that has a rate of return of 10% (meaning it grows my money by 10% each year), then that means that each year, my money is 10% more than what I had the previous year. So basically, each year, my wealth is 110% of the previous year’s wealth. To put it another way, I multiply my wealth by 1.10 each year.
|End of Year 1:||$10,000*1.1||= $11,000||(an increase of $1,000 this year)|
|End of Year 2:||$11,000*1.1||= $12,100||(an increase of $1,100 this year)|
|End of year 3:||$12,100*1.1||= $13,310||(an increase of $1,210 this year)|
|End of Year 4:||$13,310*1.1||= $14,641||(an increase of $1,331 this year)|
|End of Year 5:||$14,641*1.1||= $16,105||(an increase of $1464.1 this year)|
…and so on
You’ll notice that each year, the amount of money in the account grows by more than it did the previous year. This is because it takes the balance that’s in there and grows it by 10% each year, and since there is more money to grow, more money is made. In this example, at the end of year 30, I’ll have nearly $175,000 in my account, which is over 17 times my original investment. Even when inflation is considered, my wealth will have increased dramatically.
How to build wealth by compounding
If you set $400 per month away in a Roth IRA, you’ll be saving $4800 per year. If you continue investing an inflation-adjusted $4,800 into your account each year for 30 years, and as in the above example manage to achieve a rate of return of 10%, you’ll have slightly over $1 million in your Roth IRA at the end of your 30th year. There will be inflation of course, so if we assume that inflation occurs at a rate of 3% each year for those 30 years, then your $1 million will have the buying power that $437,000 has today. Not bad for only $400 per month!
Of course, there are tons of options today. Many people use 401(k) investments where their employer matches a certain percentage of their input. If all of your retirement options are maxed out, you can also open a taxable brokerage account and invest more. As your income stream from work or business grows, you’ll be able to contribute more money each month, accelerating your gains. It’s not out of the question to make a few million dollars before you retire if you start early, obtain reasonable income streams, minimize your costs, and invest wisely. Keep in mind, also, that although it does take a while to grow this kind of wealth, you’ll be achieving higher and higher levels of wealth throughout the entire process, and after a relatively short amount of time, you should be in a position where finances are of little concern to you.
Dividend growth compounding
I don’t focus only on net worth, though. I primarily focus on the potential passive income streams that my net worth can provide me, and focus on choosing investments that grow their dividends over time. If, for example, someone makes $15,000 in annual dividend income today, but has chosen investments that grow their dividends by 8% per year, then in 20 years, the annual dividend income will be $70,000. If those dividends (assuming a 3% yield) were reinvested into more dividend-paying companies that whole time, then the annual dividend income will be over $110,000 on the 20th year.
What we can take away from this
I’m not saying not to work. The manager I speak of loves his job. But at the same time, he should be also focusing on growing his wealth, or more specifically his passive income streams, exponentially. The path to wealth is to make your money work for you so that you can work on what you want to.