So you’ve got a job, and you’re saving money consistently each paycheck … now what do you do with the money you’ve saved up? This is where we shift from saving money for the short term to investing money for the long term.
To understand the importance of focusing on the long-term view with investing, let’s take a look at an important and powerful concept…
Key Concept: Compound Interest (or Compound Growth)
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Compound interest, or compound growth, is the process of reinvesting interest or income on an investment to amplify the growth of the investment over time. If you think back to your math classes, it results in exponential growth rather than linear growth.
The dramatic effect of compound growth
Here’s an example showing the impact of $10,000 saved each year growing 6% annually over a 40-year period. The total contribution is simply 40 x $10,000 or $400,000. That’s the yellow line near the bottom. With simple interest, that is, interest earned each year but not reinvested, that would grow to $891,400 or a little over two times the total amount contributed. That’s the red line in the middle.
The blue line shows the effect of compounding. You can see the exponential growth of the blue line to a final amount of over $1.5 million or close to four times the amount contributed!
This demonstrates the power of compounding and also how time works to your advantage. Notice that at 10 years, all three curves are pretty close, but as time goes on they really start to separate. In year 30, for example, the compounding example increases year-over-year by $54,184, but you are only contributing $10,000 so most of that increase is just from the growth of the current account balance.
Compound growth is a snowball effect that builds over time.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
We are going to get deeper into investing later on, but for now, the key things to keep in mind are:
- as long as you are saving regularly from the simple budgeting approach, you’ll accumulate at least 20% of your net income each year. In our previous paycheck example that would be $11,453 a year.
- some of that may be going directly into an investment account through a 401k savings plan and the rest will likely be accumulating in a traditional savings account, which pays some interest, but probably very little (maybe 1% to 3%).
- each year, you can take the additional savings you’ve built up and transfer it to your investment or brokerage account and then invest it in ways that can deliver better long-term returns than your savings account will.
Later we will look at the two primary asset classes for investing money: stocks - pieces of ownership of companies, and bonds - loans you make to a company (or the government) that pay you interest.
We’ll also look at different structures for those investments: mutual funds and ETFs, which pool lots of different stocks or bonds together that spread the risk and eliminate the need for you to make individual stock or bond selections on your own.
There are of course, many other types of investments, but most are variations on these two basic types and you don’t need anything more complicated to create a portfolio that will build wealth over time.
For most people, a large stock index fund, like an S&P 500 fund, and a large bond index fund, like the US Aggregate Bond fund, are all you need to build a sensible portfolio.
If you simply follow these steps of saving money each month, investing the balance each year in diversified, low-cost index funds, and letting your investments grow over time, you’ll have a very high likelihood of being financially set in your retirement and will end up better off than probably 95% of other people.