What is often referred to as the “power” or “magic” of compounding interest is actually a difficult concept for most people to comprehend.
It’s slow, silent, boring and intangible. Not exactly something one would equate with magic and power.
The greatness of it is hard to even explain until you begin to experience it, myself included. In 2005, I rolled over several 401(k)s into my first IRA after working for several companies in Atlanta and Virginia. In 2008, I rolled over the 401(k) from my Albuquerque job since we had moved to Los Angeles. Around 2013, I added pension funds from two prior companies I had worked for who no longer wanted to hold my funds.
Since then, I’ve added no additional funds to this account. With moving, new jobs and the Great Financial Crisis of 2008, I really didn’t pay much attention to it until 2018 when I noticed the increase in balance, slowly but steadily. It’s when I began to realize the tangibleness of compounding interest because I had added nothing to this account for years.
The historic annualized rate of return for this account is 9.36%. I don’t know if that is inflation adjusted. The personal rate of return I calculated for the S&P 500 since I started investing is 9.29% inflation adjusted. That is what I consider in my own terms the most unintentional beating of the S&P 500 ever.
In the first several years, the growth from compound interest is slow especially when it coincides with a down market. As the investment grows and the accumulated return or interest starts generating its own returns, you’ll notice the pace of growth begins to pick up.
The “explosive” or “exponential” growth typically occurs in the later years of an investment where the accumulated returns from previous years produce significant new earnings. My first rollover IRA has entered that realm of exponential growth after 20 years.
Compound interest or investment returns accelerate over time, more specifically decades. In my see-it-to-believe-it Time Value of Money spreadsheet, I show the calculations for each year from the initial investment amount to the amount it would grow to after 30+ years.
I’ve added calculations to this Excel file with a second tab where I calculate how much the interest or returns compound in the first 10 years vs. the next 10 years and then the next 10 years. I don’t add any amounts to the initial investments nor subtract from them to keep it simple and demonstrate how compound interest does gain powerful momentum becoming somewhat magical in later years.
Take the one with the initial investment of $100,000. My IRA had just over $50k at the onset and then I added another $50k by 2013. So, it won’t follow this example exactly because a spreadsheet can’t replicate precisely what happens in life. It can only help you understand it.
After 10 years at a 9% rate of return, the $100k investment will grow about $27.7k. It is in the next 10 years when the investment reaches the 20-year mark that the exponential growth can start to be seen when the investment has grown another $174.7k. And then when it reaches the 30-year mark when the “magic” is truly realized.
If you sum the original $100k with the increases in years 10 and 20 (cells B10:B12), the total is lower than what my IRA balance shows because that 9% rate of return is just an average. Some years it is vastly lower or negative and this year-to-date it is 19.30%.
Since the large, delayed reward isn’t realized until after the 20 – 30 year timeframe, the short-term mindset will bail with the next market downturn seizing their opportunity for exponential growth.
I came across a Bogleheads thread circa 2019 where the original poster (OP) asks when the power of compounding really kicks in. Many wrote they had not realized it yet or that it was a “bunch of hooey” or “hoax” since they were well below that 20-year threshold. Or that interest is what you earn in a bank account, not in the stock market. Several attempted to explain it but met with opposition by those who didn’t understand it.
If you still have doubts, keep contributing to your retirement plan, keep investing in your Vanguard account, the exponential compounding will eventually kick in even when you are retired. Believe me, I’ve taken the calculations out to 100 years including withdrawals.
Ultimately, the key to unlock the power and magic of compound interest is time. It’s a tough reality for those who don’t understand it, start investing late or only chase the highest returns.
Over the last week while I was searching for trustworthy, supporting sources, despite every attempt at rewording it, the search returned highly technical articles with all the complex equations or unimpressive ones. So, I started searching on “Images” and found Ben Carlson’s chart from his post on Compounding in the Stock Market is Messy – A Wealth of Common Sense.
Ben still writes far more frequently than I do and has written for far longer. He is an educated, experienced investor with a wealth of common sense on not only investing but also personal finance. It’s why I often use his writing to support mine as an unintentional investor and as proof that I’m not making this stuff up.