The power of compound interest is the most powerful force in the universe. - Albert Einstein (Allegedly)
Grandiosity aside, whether it was Einstein or someone else who first said that, it gets the point across. Compound interest (which is interchangeably referred to as compounding and compounding growth) is incredibly powerful. The good news is that anyone with an internet connection can harness its power with close to zero effort or cost.
We are far from the first people to take a swing at communicating the value of compounding. It's like Unchained Melody, eventually everyone does a version of it. But we feel its level of importance can't be overstated, and that Capital MONEY! may offer a perspective that adds value to our community.
What is Compounding Growth?
For investing, compounding growth is the investment returns generated by the accumulated reinvested returns plus the original principal. More simply.. your money makes money, and then the money your money made makes more money.
It would be like if you paid one person $10,000 dollars to do a job for the rest of their life. But then a few years later at no cost to you they brought one of their friends to also do the job. A few more years go by and those two people each bring a few more of their friends to work for you and they're all just as good as the first person you hired. Now you have an army of people working for you and all you ever did was pay the first one $10,000.
Seems too good to be true, but that is what compounding growth is. Except your employees are dollars. And all your dollars will work hard for you for the rest of your life and bring their little dollar friends to come work for you too.
Why You Should Care
Compounding growth is the easiest and most certain way to double, triple, 10x or more your money over the long term. Anyone can harness the power of compound interest for ~free (more on MERs later) by opening an online investing ("Brokerage") account and buying shares in an index fund such as any of the ETFs listed in our 10 Steps Guaranteed to Build Wealth article.
Below we outline the level of ease and certainty with which you can reasonably expect compounding growth to make you lots of money over the long term.
Ease
- Open investing account (5 minutes)
- Transfer cash into investing account (1 minute)
- Buy ETFs (1 minute)
- Don't sell ETFs and let power of compounding make your life a lot better (0 minutes)
- Total time investment: 7 minutes
Certainty
List of All Scenarios in which Compounding Growth Will Not make you lots of money over the long term:
- Total societal collapse
List of All Scenarios in which Compounding Growth Will make you lots of money over the long term:
- Everything other than total societal collapse
- Those are good odds
- If society collapsed, whatever you had invested in instead of ETFs would also be worthless. Cash and the monetary system would necessarily be worthless. Real estate and physical items would only be as valuable as you were willing to fight off post-apocolyptic pirates for them.
- Capital MONEY! is not aware of any investments with higher expected returns, lower risk, or less effort
Recap
- Question: Is harnessing the power of compounding right for you?
- Response: If you want to have a lot more money than you do now, can spare 7 minutes, and believe there is a low chance of total societal collapse and/or you don't want to fight off post-apocalyptic pirates, then yes. Harnessing the power of compounding is right for you.
Alright, so that is a bit of a ridiculous way to summarize the scenario. But the fact is that it's the most accurate way to think of it as an investment decision. Figure 1 & Figure 2 below show how much money you would have after 35 years of compounding at 7% interest (return) with an initial investment of $10,000. They show how $10,000 becomes $106,766 on its own. Without any effort or thought, compounding growth will take your $10,000 and give you another $96,776 for your patience.
- 7% return net of inflation is inline with historical returns. Though past performance does not guarantee future results, it is the best comparison point.
- This does not require you to put any additional money into it over the 35 years, it just keeps working for you.
Context and Additional Information
What is an ETF
First we'll explain what an ETF is and why we cite it as the way to harness the power of compounding interest. ETF stands for Exchange Traded Fund, which simply represents an investment fund (a method of investing money with a pool of other investors with a shared strategy) that is traded (bought and sold between owners) on stock exchanges (NYSE, NASDAQ, etc).
That is more or less the textbook definition of an ETF, but it's probably not very insightful for anyone who wasn't already familiar with them. In practice, ETF is generally a fund that directly tracks a specific stock index, such as the CRSP US Total Market Index "which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq" such as Vanguard's VTI (Ticker*) ETF.
*An aside on ticker symbols aka tickers: a ticker symbol is the generally 1 to 4 letters used to represent shares of a company or fund that is traded on the stock market. For example Vanguard's total US Stock Market ETF's ticker is VTI, Microsoft's ticker is MSFT, Apple's ticker is AAPL, and Amazon's ticker is AMZN. Just to name a few of the many thousands of tickers that exist.
Continuing with the VTI ETF example. Since VTI follows the CRSP US Total Market Index, its fund managers (the people who run it) don't need to make any specific investment decisions. They just need to buy stocks of companies in the same proportions that the stocks are in the CRSP US Total Market Index.
Suppose that the CRSP US Total Market Index only had two stocks and was comprised entirely of 60% Apple and 40% Amazon. Then if VTI had $100 million in funds, its fund managers would invest $60 million in Apple and $40 million in Amazon. And their ongoing job would be to ensure that the fund continued to match the same proportions of the CRSP US Total Market Index.
That is exactly what ETFs do except on a much larger scale. For example, the CRSP US Total Market Index has 3,999 stocks in it.
Choose Passive over Active Funds
An ETF that tracks an index is referred to as a passive fund, the alternative to which is an active fund. An ETF is considered passive because its fund managers aren't making specific investment decisions of which stocks to buy or sell, all decisions are made for them based on the Index that the fund has declared that it tracks.
Conversely, the managers of an actively managed fund are frequently making decisions to buy or sell specific stocks based on their research, investment philosophy, and temperament. Essentially, active managers try to outsmart the market, while passive fund managers copy the market.
Minimize Management Expense Ratios
Which brings us to Management Expense Ratio (MER). MER is expressed as a % and is the amount of money that the fund managers take out of the fund assets and pay themselves for the running of the fund. A fund with an MER of 1%, each year will take $1 out of every $100 you have invested with them. A fund with an MER of 0.5%, each year will take $0.50 out of every $100 you have invested with them.
Actively managed funds often have MERs in the 0.5% to 2% range. Meanwhile ETFs usually have MERs in the 0.03% to 0.05% range. Yes, that's not a typo. ETF MERs really are that low. The difference in MER between an ETF and an actively managed fund may not seem like a lot, but even a 1% difference in MER has a huge impact on your overall returns.
Assume that two funds got the exact same investment returns of 7.03%, but that one's MER was 0.03% and the other one's was 1.03%, for a net annual return from each fund of 7% and 6%, respectively. Figure 3 below shows how over 35 years the 1% difference resulted in 299% lower ROI. The 7% Annual Rate of Return (ARR) generated $96,766 investment returns, 45% more than the 6% ARR over the same period.
Managers of active funds would argue that their MERs are justified by their investment brilliance and that you get what you pay for. However results and studies continue to show that you actually get what you don't pay for when it comes to investing.
Almost no active fund managers achieve returns greater than the total stock market (what you can invest in with an ETF), even before they deduct their MER fees.
We hope you enjoyed this article. Please share it with others if you think it can provide value to them.
Capital MONEY!
Figure 1:
Recall from above... More simply.. your money makes money, and then the money your money made makes more money. Linking that to this chart..
- your money makes money: gray dotted line
- the money your money made makes more money: green dash line
- this accounts for 75% of total returns! see Figure 2 for more details
Figure 2:
Figure 4:
- Shows the underlying details of the data in Figure 3
