The closest thing you’ll find to actual magic in the world of investing (well except of course from Enron’s accountants) is compound interest. It sounds boring. You put money in the bank and it ‘compounds daily’. Boring. But compound interest over long periods of time are so spectacular that they are almost unbelievable. Let’s say you had some far-sighted relatives who left you just $10, 200 years ago, and they were able to invest that money at 10% compounded over that entire period. How much money do you think it would have grown to? $100,000? $1 million? Try $1.9 billion dollars. Don’t believe me, get out your HP 12C and try it for yourself.
Of course, you can’t wait 200 years to be able to use your money. But that magic is probably the single most important factor in gaining true wealth. $50,000 invested at 12% over a 20 year period grows to over $500,000. And that’s well within the reach of the 401k accounts of many people.
There are downsides to compounding too. One is that some insurance agents will use it to make almost any kind of annuity, universal or whole life policy look like a great deal. They may carry huge fees, but the power of compound overcomes that and makes a relatively poor investment look great.
The place where compounding really works against you is when you take on debt for long periods of time. Now I’m not talking about a mortgage here, that’s a low interest investment with a big income tax deduction (in the US). But if you pay for that $3,000 trip to Cancuun with your 15% credit card and make those minimum $50 a month payments, it will take you 10 years to pay it off and the trip will have cost you $6,000. Unless you find a spouse on that trip, all you’ll have is memories and you’ll be paying for them for 10 years.
However, if you put off that trip and go camping instead, that $50 a month invested at a compound 12% would be worth $11,000. Make one vacation plan change, and you could be $11,000 ahead. See? Magic!
Let compounding work for you, not against you.