Albert Einstein, who knew a few things about math, considered compound interest the ninth Wonder of the World. The greater time compound interest has to accumulate, the more money you can potentially earn in the end. Here are a few reasons that explain exactly why Einstein thought so highly of interest.
The Miracle of Compound Interest
Einstein knew that small changes over time could produce profound changes. He may have thought about the movement and speed of light over time, but he also applied it to money and investing. His methods, however, may have been a bit complex, so check out Fisher Investments on the Street for more simplified lessons on investing.
So it should come as no surprise that over time, any amount an investor can put into the market, while earning a modest return, will produce a large result over time. That's why many financial professionals say that being a long-term investor, as opposed to a trader, is beneficial. After all, successful investing is more of a marathon than a sprint.
Stocks vs. Bonds
Once new investors appreciate the benefits of compound interest, they have to face the basic differences between stocks and bonds returns over time. But here's a hint: Over any multi-decade time period, the returns from equities beat bonds. This has been verified by numerous studies of historical returns.
One study using a 50-year annualized return for U.S. stocks versus U.S. corporate bonds from 1959 through 2008, found that stocks produced on average 9.18% annually, while bonds earned an average annualized return of 6.48%. These returns also illustrate that the risks associated with each investment. The rule of thumb in investing is the greater the risk, the higher the return potential.
The Penalty of Prognostication
The power of compound interest is evident over time. Here's an example comparing one investor who started saving early compared to another who procrastinated.
This example, courtesy of the U.S. Department of Labor, illustrates the power of compound interest by comparing two employees, both of whom saved $1,000 a year. One employee saves when she is 20 to 30 years old. A second co-worker starts saving at age 30 and continues until he is 65.
After a decade, the first employee, who only contributed $10,000, ends up with over $160,000. The second employee, who contributed $35,000, ends up with about $139,400, or about $34,000 less than his co-worker. The reason: his money did not have the same lengthy opportunity to amass compound interest. (The DOL used a 7% interest rate to calculate the investment return used in this example.
Investing Is Less Risky Over Time
While it may seem counter-intuitive, the longer an investor stays invested in the equity markets, the lower their risk. Yes, there is short-term volatility which can make professional traders weak in the knees. Studies show that over time, the best way to improve equity gains is to stay invested. At the same time, risk is reduced.
One example, using historical data from 1950 through 2005, compared investment returns over different lengths of time for small-cap stocks, large-cap stocks, long-term bonds and Treasury-bills. Over the short-term, small cap stocks were the most volatile. But over time, especially the 20-year-period, the volatility of equities decreases sharply as their returns improve.
The take-away here is that consistency and patience can make investing more profitable over time.