Investing | Investing Winner

The Power of Compounding Interest

Compounding interest is one of the core principles of long term investing. The basic is the more often your investment compounds, the greater your investment will become, and your investments will grow at a faster rate over time.

Compounding interest is also one of the basic ideas of the phrase “It’s about time in the market, not timing the market” — over time, as your investments compound interest, you will see greater and greater accelerated gains.

What is Compounding Interest?

Compound interest is interest added to the principal of a deposit or loan, so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding.

To put this more simply, compound interest is “interest on interest” which means your deposit will grow at a faster rate than with simple interest.

Compounding Interest Formulas

Here are two formulas you can use to calculate compounding interest yourself.

Basic formula — for compounding once per year:

V = P (1 + r)^t

Where:
V = the value of investment at the end of the time period
P = the principal amount (the initial amount invested)
r = the annual interest rate (note: this is a decimal, so 5% becomes 0.05)
t = the number of years the money is invested
^ means raise to the power of

Example for compounding $1 initial investment at 5% over 50 years:

V = 1*(1+0.05)^50 V = 11.467

Advanced formula — for compounding multiple times per year, such as daily, monthly, or quarterly:

V = P ( 1 + [ r / n ] ) ^ n * t

Where:
V = the value of investment at the end of the time period
P = the principal amount (the initial amount invested)
r = the annual interest rate (note: this is a decimal, so 5% becomes 0.05)
n = the annual frequency of compounding (how many times a year interest is added)
t = the number of years the money is invested
^ means raise to the power of

Example for compounding $1 initial investment at 5% compounding monthly over 50 years:

V = 1*(1+0.05/12)^(12*50) V = 12.119

Important: Notice how compounding more often per year yields higher returns.

Example of Compounding Interest

Here’s a quick example of compound interest:

You have invested $1 at a 5% interest rate which compounds once per year.

Next year, the $1 investment would be worth $1.05 — a gain of $0.05.
In 2 years, the initial $1 investment would be worth $1.1025 — a gain of $0.0525 over the previous year
In 3 years, the initial $1 investment would be worth $1.158 — a gain of $0.0555 over the previous year.
In 10 years, the initial $1 investment would be worth $1.623 — a total gain of $0.623.
In 20 years, the initial $1 investment would be worth $2.653 — a total gain of $1.653.
In 50 years, the initial $1 investment would be worth $11.467 — a total gain of $10.467!

Important: Notice how the gains are increasing year over year and accelerating!

Compounding Interest Over Time

Here are two graphs that further demonstrate the power of compounding interest.

The first graph shows compounding interest of $1 initial investment and a 5% return rate over a 52 year period:

The next graph shows the compounding interest power of the same $1 initial investment and 5% return rate but over a 104 year period:

These graphs demonstrate the accelerating return rate you receive with compounding interest. The interest you’re making on your initial $1 investment is making its own interest — and it’s making more and more money over time — accelerating the returns.

Visual example of compounding frequency differences

Compound Interest with Varying Frequencies

In this graph you will see compounding more often yields higher returns. Over time, the $1000 initial investment compounding yearly will return significantly less than $1000 compounding quarterly or monthly.

Takeaway: Interest compounding more frequently will ultimately yield greater returns.

Learn More about Compounding Interest

If you’d like to learn more about compounding interest and it’s benefits on investing, I’d recommend these three books:

The Richest Man in Babylon

The Compound Effect

A Beginner’s Guide to Investing: How to Grow Your Money the Smart and Easy Way

How to Create a Budget

Defining your financial goals, creating a budget, and reducing expenses is the first step to becoming financially secure and investing in your future.

So how do you create a budget? You can start with these five simple steps:

Set realistic goals
Figure out where your money is going
Identify your income sources
Combine your income and expenses to determine your monthly savings
Reduce your monthly expenses

Set realistic goals

To get started, you’ll need to determinine your short term and long term financial goals. Are you paying off a car loan? Saving for a house? Planning on early retirement? Once you have defined your goals you can start organizing your finances and working towards completing your goals.

Figure out where your money is going

Before you can manage your money, you need to know how you’re spending it. You can use excellent tools such as mint.com or spreadsheets to track your monthly income and spending.

I personally use and recommend mint.com. What’s great about mint.com is that you can import all of your transactions from checking, savings, and credit card accounts, and then you can see all of that data in one place.

With mint, you can also set up your monthly income and expenses, and easily track if you’re exceeding your defined budgets. You can see great detail on exactly what you’re spending money on each month and how much you’re spending. Want to know how much you spent on fast food last month? Or the last year? You can easily visualize that spending over time data with mint!

Once you have a good tool for tracking your expenses, you can break your expenses down in to three common categories:

Fixed needs – those necessary expenses that stay the same each month, such as your rent or mortgage payments and cell phone bills.
Variable needs – expenses that will vary from month to month, sucha s gas, electric, water, and food.
Wants – these are non-essential expenses that are not needed, but nice to have once in a while, such as going out to the movies, eating out, entertainment, lattes.

Identify your income sources

Knowing where your income is coming from and how much you can expect each month is also important. You’ll want to create a detailed list such as paychecks from work, dividend income, bonuses, and any other way you’re making money.

Combine your Income and Expenses to find Savings

Now that you know your monthly expenses and monthly income, you’ll combine them to see if you’re spending more than you’re making each month, or how much extra you’re expecting to have left over. Here are the steps:

Add up your income
Subtract your expenses from the income
Allocate the remainder of your income — your monthly savings — to your goals.

Reduce your monthly expenses

If your expenses are greater than your income (negative cash flow), you’ll want to look for ways to decrease your monthly expenses so that you can increase savings and complete your goals.

Start by examining your “Wants” category. Do you find yourself spending a lot of money each month at Starbucks on cappuccinos that you don’t really need? If so you can start working on cutting down that cost and using that money elsewhere.

Think of it like this, would you rather spend $50 a month on coffees or have $600 extra at the end of the year? I’d rather have the $600! If you then invested the extra $600 per year, then after 10 years you’d have $7,500! Not only would you have your original $6,000 you saved, you’d have an extra $1,500 from compounding interest. If you scaled this up and saved even more money each month, and invested that money, you could potentially be able to retire younger, buy more property, or significantly increase your investment portfolio.

There are many other ways in which you can reduce your monthly expenses. Start by cooking meals at home rather than eating out and by buying necessities such as toilet paper, laundry detergent, etc. in bulk. A big savings for me was to cut out cable TV and instead stream my TV with Netflix. By cutting out cable TV, I’ve saved over $100 per month!

Putting it all together

Defining your budget and setting goals for yourself is the first step towards financial security and smart investing.

Now that you’ve created goals and a budget, you can easily track where your money is going, how you’re spending it, how you’re making it, and what you’re going to do with your savings.

You’re also actively thinking about ways to reduce your monthly expenses in order to save more money, and investing those savings so that you can have a lot more money in the future.

Benefits of Investing in Index ETFs

What is an ETF?

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.

For more information, see my previous article on ETFs: Exchange-Traded Funds (ETFs).

Why Invest in Index ETFs?

An Index ETF is an ETF that tracks a specific stock market index, such as the NASDAQ 100, S&P 500, or Dow Jones Industrial Average. This means when you buy an index ETF, you gain exposure to all the stocks that comprise the index. For example, if you bought QQQ, the NASDAQ 100 index ETF, you would gain exposure to Google (GOOG), Apple (AAPL), Tesla (TSLA), CostCo (COST), and all the other stocks currently part of the NASDAQ 100 index.

The indexes are composed of a diverse set of stocks, so you automatically have exposure to various industries. If the index goes up, your index ETF will also go up. When a company in the index pays a dividend, your ETF will also pay a dividend.

Advantages to buying Index ETFs

There are a number of advantages and benefits to buying index ETFs. First, you are diversifying your holdings because the ETF is a basket of other stocks. You are also diversifying your risk exposure. A sharp decline of a single stock will not translate in to a sharp decline of the ETF because the other components in the ETF will decrease the loss and risk. If a stock in the ETF pays a dividend, you will receive a share of the dividend through the ETF. If the index the ETF tracks increases in value, your ETF will also increase in value.

Here is a break down the benefits of ETFs:

Diversification of stocks
Diversification of industries
Reduced risk
Dividend income
Top companies in the market
Tax efficient
Low expense ratios

List of U.S. Index ETFs

Here is a complete list of U.S. stock market index ETFs:

NASDAQ 100 Index: QQQ
NASDAQ Composite Index: ONEQ
S&P 500 Index: SPY, IVV, VOO
Dow Jones Industrial Average: DIA
Dow Jones U.S. Composite Index: IYY
Russell 2000 Index ETF List: IWM, VTWO
Russell 3000 Index ETF List: IWV, VTHR