4.- “The Most Powerful Force in the Universe”
Legend has it that Albert Einstein was once asked what he considered the most powerful force in the universe. He answered, “Compound interest!”
It’s commonly thought that Einstein was joking when he made that famous pronouncement. I’d like to think he was serious. Compound interest is indeed one of the most powerful forces in the universe of making money. But it’s also one of the most profoundly powerful forces in every area of human enterprise.
Whether your goal is to create a new vaccine, build a faster computer, design a better building, or eliminate poverty, the time and effort you invest in your goals will compound over time, providing you with increasingly greater rewards.
When it comes to wealth building, the more time you have to invest, the easier it is to become wealthy. So starting when you’re young gives you a major advantage. However, the advice I’m going to give you here will work for you no matter how old you are or where you are right now in your wealth-building goals.
A simple example of the power of compound interest
If you took a penny and doubled it every day for a month, how much would you come up with? A hundred dollars? A thousand dollars? How about a million dollars?
Not even close. If you start with just a single penny and double it every day for 31 days, you’ll end up with… $21,474,836.48. More than twenty-one million dollars in a single month!
Your original penny will have turned into two. But then those two will have turned into four, those four turned into eight, and so on. The growth of your money will have accelerated, or sped up, not only because your original penny was collecting interest but also because all the pennies your received as interest also began to earn interest. And so the growth built up – or compounded.
That’s how we get the term compound interest.
There are three components to compound interest:
- How much you invest
- What return you get on your investment
- How much time you stay invested
I’ll be coming back to these components over and over again, because they are the fundamentals of wealth building. And when they are put into action simultaneously, the effect is huge. Anyone – even someone that is inexperienced and working with a limited income – can become enormously wealthy by putting these three components to work at the same time.
I’m going to try to prove to you that you can develop wealth automatically by doing the following things:
- Begin investing right now – this year – and keep investing more every year until you’re rich.
- Find ways to earn above-average returns on your savings.
- Put an increasingly large percentage of that extra income into your savings until you are wealthy enough to stop working.
Compound interest is a curve that begins to rise slowly and arches up. Every year that passes, you will see your wealth building faster than it did the year before. Yes, there may be years when the market turns against you. But if you stay invested in quality positions and stick it out, you will reap the gigantic benefits that the nature of compounding gives you.
At some point in time, you will notice that your net worth is rising like an air balloon, propelled upwards almost magically, making you richer even if you aren’t paying it any attention. That is why rich people – even the laziest among them – seem to get richer.
It’s not that they are smarter than everyone else. It’s just that they are in a position where their wealth is being supported by the skyrocketing buoyancy of compound interest.
So of the three components, time is certainly the biggest one.
And, as I said, when you are young, time is on your side. Because if you invest a modest amount of money over a long period of time, you can easily become wealthy.
Not yet convinced?
Let’s begin with an assumption that probably isn’t true…
Let’s say you have $30,000 in your bank account right now. One thing you could do with that $30,000 would be to buy a new car – say, a new BMW sedan. Having a car like that would definitely provide you with a good deal of fun and a sexy way to get from place to place. But what would it do to your wealth-building prospects?
The minute you drive that car off the dealer’s lot, its value is diminished by almost $8,000. (I’m using industry averages.) That means, in effect, that you’d be $8,000 poorer. Five years later, that same car would be worth something like $13,000, giving you a negative net worth of $17,000. Hold on to the car for another few years, and it would be worth no more than its weight in scrap metal.
This decline in value over time is something financial people call depreciation.
In terms of your future wealth, investing $30,000 in that BMW was evidently a bad choice. Agreed?
Now let’s imagine that you purchased an older model – essentially the same car, but just five years older, for $20,000. And let’s say that you invested in the stock market the $10,000 you saved by not buying the new BMW.
Your five-year-old BMW would continue to depreciate, just as the new one would. But the rate would be less dramatic, because the big haircut (jargon for depreciation or discount) would already be a done deal.
But while your car depreciates, your stock investment appreciates. For the purpose of this discussion, we are going to assume that you put the $10,000 you saved into a no-load mutual fund that tracks a major stock index. Such an investment could reasonably be expected to return at least 10 percent a year over 20 years. How much would you have then? You can find the answer yourself by going on the Internet and using a compound-interest calculator – but I can tell you it would be almost $70,000. And after 40 years… you’d be more than half a million dollars richer.
You can see the point I’m making, can’t you?
If you spend $30,000 on a BMW now, you may feel good momentarily. But in 20 years, you’ll be $77,000 poorer than you would be if you were smarter now. And that difference is the result of a one-time investment. Just think how much wealthier you’d be if you continually added to that investment.
Start saving right now!
Could you get rich without the miracle of compound interest? Yes, you could. You could win the lottery one day. You could get discovered and become a rock star. You could give a hitchhiker a ride and inherit his fortune.
That could happen. But it probably won’t.
If you commit yourself to the Wealth Building for Beginners plan now, you won’t have to worry. You’ll have your cake (a multimillion-dollar bank account) and eat it too (enjoy your life and career). It’s entirely up to you.
To take full advantage of the miracle of compound interest, you must begin to save and invest immediately. I recommend that you set an aggressive saving goal for yourself: 15 percent of your pretax income. That might sound like a challenge. It is. But if you are willing to make some reasonable sacrifices (like driving a used car and maybe sharing an apartment), you’ll be able to do it.
* In this series of essays, I’ll be updating and revisiting ideas from several of my books on wealth, including two first published by John Wiley & Sons: Automatic Wealth and Automatic Wealth for Grads… and Anyone Else Just Starting Out. Plus several hundred essays published over the past 17 years in a variety of financial newsletters, magazines, and books.
