The Power of Compound Interest in Building Wealth

In our society, we are quick to compare ourselves to people who appear to be overnight successes. We think that we can only become wealthy if we’re a movie star, pro athlete, or social media influencer. However, this is not how most people become wealthy. A misconception that a lot of people have is that you need to be earning a lot of money to become wealthy. Not only is it possible to become wealthy from a normal salary, but a lot of the millionaires out there don’t even make six figures a year.

A study that was conducted by Ramsey Solutions surveyed over 10,000 millionaires across the country and they found that most of these millionaires don’t earn high salaries with the top five careers of these millionaires being engineer, accountant, teacher, management, and attorney. One-third of these millionaires never earned six figures in any single working year of their career. Also, most of these millionaires didn’t get all of their wealth from mommy and daddy with roughly 80% of them not receiving any inheritance and only 3% of these millionaires received an inheritance that was over $1 million.

So what is the secret to these millionaires building their wealth? Well, it would be what Albert Einstein called the eighth wonder of the world, which is compound interest. Simply put, the Consumer Financial Protection Bureau defines compound interest as earning interest on the money you save and on the interest you earn from that money along the way.

To help you understand what this means let's say you invest $1,000 into the S&P 500, which is an index that is composed of the 500 largest companies in the United States and has seen an average return of 10% every year.

At the end of the first year, your investment would grow by 10%, earning you $100 in returns. So, your total investment would now be worth $1,100. In the second year, assuming you get the same 10% return, your investment would grow by $110, so your total investment would now be worth $1,210.

As you can see, with each year that passes by, not only does your investment grow, but the rate at which it grows also increases. If you keep this money invested in the S&P 500 for 40 years you would have roughly $45,000.

Just to clarify, the S&P 500 doesn’t go up 10% every year. The returns vary each year, with some years seeing gains and other years experiencing losses. Let’s take a look at this graph that shows the growth of the S&P 500 over the past 40 years. In 1984, it was only $155 and it recently hit an all-time high of $5,000. You can also see there have been quite a few dips over the years, but over time the S&P 500 has always recovered from them.

While no one likes to watch their investments go down, history has shown that staying invested in the market can result in you becoming wealthy over time. This is why a lot of seasoned investors say that “time in the market beats timing the market”. No one can predict what the market is going to do in the short term, but we know that in the long term, the market will continue to grow.

I learned this lesson quickly back when I started investing. During my senior year in high school, I opened up a Robinhood account and put about $500 into various stocks. I had no idea what I was investing in, but in a couple of months, my portfolio was up by a few percent. I thought I was a genius investor, but reality was about to kick in for me.

The year was 2020, and we all remember what happened that year. When the world shut down because of Covid, the stock market tanked. Not only did I lose all of my gains, but I also lost roughly half of the money that I invested. I was devasted by this, but luckily, I understood early on that staying invested in the market and keeping a long-term perspective was important. Instead of selling off my portfolio, I chose to ride out the storm because I was confident in the resilience of the market. This decision proved to be the right one for me to make, as the market recovered quicker than expected. I was able to recover my losses and continue building my wealth.

Not only is staying invested in the market an important factor in building your wealth, but for compound interest to work its magic, you must start investing as soon as possible. Time is the most important factor of compound interest, as it allows your investments to grow exponentially over the long term. The earlier you start investing, the more time your investments have to grow.

Let’s take a look at an example that shows how time makes such a difference in the growth of your investments:

Thing 1 starts investing $200 a month into the S&P 500 at 20 years old, and at 30 years old, they stop making contributions, but they keep their money invested in the S&P 500 over the next 35 years. Thing 2 starts investing $200 a month into the S&P 500 at 30 years old and continues to do so until they're 65 years old.

Assuming an annual return of 10%, let's compare how much they both will have at 65 years old.

Thing 1, who only made contributions for 10 years, but kept their money invested for the next 35 years has a portfolio that’s worth roughly $1,337,000. Thing 2, who started investing 10 years later than Thing 1, but made contributions for 35 years has a portfolio that’s worth roughly $759,000.

Were you surprised by these results? Thing 1 contributed $24,000 of their own money while Thing 2 contributed $84,000. The reason why Thing 1’s portfolio is roughly $600,000 more than Thing 2’s portfolio is they were invested in the market for 10 years longer. This shows us the importance of time when it comes to building wealth.

Don’t feel like it’s too late for you to start investing. Regardless of your age or financial situation, you must start your investment journey as soon as possible so that you can let that compound interest work its magic. Even if you only have $1 to invest, open up a brokerage account and invest that $1 now. I get that it’s not that much, but it’s all about shifting your mindset. You need to understand that by investing your money now, you’re taking a step towards building your wealth. Every dollar you invest has the potential to grow over time from the power of compound interest. So, don't underestimate the impact of even the smallest investment – start now and watch your wealth grow!!!