The Magic of Compounding

​Warren Buffett has said the most powerful factor of his success is compound interest.  Einstein called compound interest the eighth wonder of the world.  It’s the idea that even with a small annual increase over a long period a time, a small account balance can grow to a substantial amount. ​

This post originated from a Financial Guide I wrote for my kids a couple of years ago, so it is directed to someone who is about to start their career.  Rather than preach the idea to my kids, I wanted to show them mathematically why it’s so important to save, invest, and to start as early as possible. 

If you are no longer in your early 20’s, the math won’t be as fun, but you will get the idea.  It wasn’t until I saw actual examples of compounding that I got motivated by the concept myself. 

Let’s assume you get out of school at age 22 and you receive a job offer making $80,000 per year.  We will estimate net pay after tax of $60,000.  Let’s say your pay increases 6% per year on average (cost of living and promotions) and you save 15% of your gross income, or $12,000 per year and earn 6% per year on your investments.  None of these assumptions are overly optimistic.   As shown below, you will be a millionaire by age 45 and a multimillionaire by age 56 (example 1). 

You may find that saving 20% or even 25% is not that painful.  If you are married with a duel income and no kids, you should increase the percentage.  This way you have the flexibility to lower it significantly if you decide to have kids and live on one income.  

As you become a better investor, you may generate higher investment returns as well.  For example, if you earn 8% instead of 6%, and save 20% instead of 15%, you will become a millionaire by age 40 and a multimillionaire by age 50 (example 2).  The concept is simple, but not easy.  The key is consistency, patience, and discipline.