Today, we delve into a lesson on investing and how you can get ahead for the future you want for yourself and your family. This is especially important for all you FIRE seekers.
Compound interest is commonly known as the “8th Wonder of the World”. Think of it like a snowball effect. The snowball gets bigger and bigger over time. The investment advice commonly doled out to the public is tuck away 10% of your paycheck and then in 80 years, you’ll be rich! However, the average lifespan in North America is about 80 years old. You can probably see the flaw in that advice. They don’t tell you that by the time you get to your financial goals, you’ll be dead, or disabled, or pissing yourself in a wheelchair. And they also don’t tell you that inflation will probably have ate half your wealth away. Put it this way, a nice salary used to be able to support your family with a nice house, car, and some money left over for entertainment. In today’s age, a nice salary is mostly used for basic expenses such as shelter and food and doesn’t get you very far in life anymore. It only gets worse overtime as assets inflate at a much higher pace than incomes.
The formula for compound interest is FV = PV x (1 + r)n. It looks complicated but it’s actually really simple once I break it down. Future value (FV) is present value (PV) multiplied by your rate of return (r) and (n) is the number of years. From this formula, if you want the highest FV possible, there are 3 variables you can play with.
PV is your starting capital and is usually the hardest part to amass. You have to hustle hard for it and make sure you have the discipline not to blow it away so you have a sizeable amount to invest with. No matter how high your return is, if you double your money but you only invest $100, you end up with $200.
Return (r) is your other variable and is often overlooked. This variable is how fast and big you can pack your snowball. I used to aim for 7% with ETFs but after religiously putting away my paycheck every 2 weeks in the stock market, during these past 6 years, I’ve noticed that my account is increasing linearly because of my contributions but isn’t really growing at all. Since investing in real estate, the tax benefits and massive returns have really helped me achieve FIRE that much quicker.
A quick and dirty method is the Rule of 72 where you divide 72 by your rate of return (r) and it should give you the number of years to double your money. If you invest $100,000 at 7%, it should double in about 10 years. 72/7 = 10.29 years.
Now here is where the magic of math gives us clarity on why returns matter so much.
You have $100,000 to invest. PV = $100,000
Our timeframe is 10 years. n = 10
After 10 years, your future value (FV) will be:
- @ 7% rate of return, your $100,000 will be $196,715
- @ 14% rate of return, your $100,000 will be $370,722
- @ 21% rate of return, your $100,000 will be $672,750
You’ll see that a 14% return is not merely double the return of 7%.
21% is not merely 3x the return of 7% but almost 6x.
You can see the power of compound interest and why returns matter so much. Even 14% is a much more powerful wealth multiplier than 7%, which is thrown around so often these days. We have easily helped our investors achieve these returns. Principal mortgage paydown ALONE is 7% and snowballs every month as less of your mortgage payment goes towards interest and more and more goes towards your principal.
Not only is it important to delay gratification so you can start investing at a young age and let compound interest work its magic, but it’s just as important to strive for high returns to really propel you towards your financial goals.