I used to have a partner in a real estate company. He was great guy and an inveterate gambler. He loved to shoot craps in Las Vegas.
Once when we were there together he took me to the craps tables at one of the high-end casinos on the strip. He watched the tables for a while until he identified the one that he felt was hot. He took his turn rolling the dice and started making lots of different bets on the table. I was completely clueless to what he was doing. I don’t gamble.
To keep me interested he staked me a few hundred bucks that followed his play. We were there about 15 minutes and he doubled our money.
I was blown away. I walked away with a good chunk of money just like that.
I used to work in the television business in New York City and my boss was a legend in broadcasting. He was street and school smart. He had a master’s degree from Columbia University in mathematics in probability and statistics. He wrote his thesis on the probability of rolling dice.
Every year we would all attend a big convention in Las Vegas called NAB. My boss would hold court at the Sands rolling serious dice. He would always attract a crowd.
These two stories are etched in my mind. What happens in Vegas stays in Vegas, except when you’re me and want to make a point.
Doubling your money in Vegas is an exciting thing. It’s also a low probability event. It’s speculative and high risk. You can lose it all. It’s gambling. The house has an edge.
Compound interest is a way to double your money that is high probability. It’s pretty much a sure thing. It is how investing works.
The Incredible Power of Compound Interest
Compound interest is the mechanism by which wealth is created. Savings is the key but savings alone will not make you rich. You need to invest your savings. You must embrace the twin concepts of time and compound interest work their magic for you.
Lets start by getting some intuition around the power of compound interest and how long the alchemy of wealth creation takes.
The rule of 72 is a shortcut for estimating the number of years needed to double your money at a particular annual rate of return.
The rate of return means how much your investments grow on average each year. For example the stock market has returned over 10 percent over the past fifty years or so. The average annualized return of the S&P 500 Index was about 11.69 percent from 1973 to 2016.
The S&P 500 Index is a basket of the 500 biggest companies on the stock market. It is a useful measure of the ups and downs of the overall stock market. We will get into this in more detail along with lots of information so you can invest wisely and put the best executives and companies to work for you. You will be their boss.
For now just know that if you invested in the stock market in the 1970s until now you would have made over ten percent on average each year. “On average” is an important phrase here because the stock market goes up and down quite a bit in the short term. You want to put your money in for the long term and let time, averages, and compounding work for you.
Now back to the rule of 72. The rule says that to find out how many years it will take to double your money you divide the percentage rate into 72:
So if you average 11% it takes about 6.5 years to double your money.
At 10% it will take 7.2 years
At 9% it takes 8 years
At 8% it takes 9 years
At 7% it takes 10.3 years
The time varies but it happens. It is inevitable that it doubles.
Think about if you went to Las Vegas and gambled and doubled you money. You would consider yourself incredibly lucky. With investing you can be pretty certain you will double your money. The only difference is time. Embrace time and let it work for you. Think of the old Rolling Stones song Time Is On My Side.
Years required to double investment = 72 ÷ compound annual interest rate
The impact of compound interest is incredibly powerful. It is the most important concept to understand for building wealth. Here is an example:
If you invest $20,000 when you are 26 years old and receive an annual return of 9% you will have:
$20,000 at age 25
$40,000 at age 33
$80,000 at age 41
$160,000 at age 49
$320,000 at age 57
$640,000 at age 65
9% may not seem like a lot but over the years the effect of compounding is huge. This example is just assuming one investment at 26. Think if you get on a program of investing continuously each month and year adding more money to your investment portfolio. You can now see that becoming a millionaire is a very realistic goal.
How much do you want it? If you are willing to change your mindset and habits to accommodate wealth building you will make it happen.
We discussed a bunch of ways to start redirecting your money and saving. Quit bad habits, stop splurging, and start saving. Remember the rule of 72.
Since 1871 the US stock market has a compound annual growth rate of just over 9%. That is a trend that will most likely continue give or take a bit. It’s a realistic compounding number for planning, and 9 percent works out to a round number for easy math.
Your mileage may vary but just by putting your money in an S&P 500 index fund you will be on this track.
This isn’t a get rich quick scheme. But it is a get rich plan. You can do this and it won’t take too much of your time and you don’t have to be a genius. Read on and prepare to take control of your money and your future.
Compounding interest separates the rich from the broke. Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
When you get into high interest debt, you are fighting against the inevitable force of compounding interest. This is why you have to extricate yourself from the grip of credit card debt first and foremost.
Time is on you side
You have to get comfortable with longer time frames. We live in a culture that runs on instant gratification.
We just went over an example of how compound interest and investing for the long term builds real wealth. It takes time and you must become comfortable with that concept. The good news is that when you invest now you know you will build real wealth over time. You can plan it out with the rule of 72 and other simple planning tools I will show you.
Forty years may seem like a long time but think about being respectful to your future self and your loved ones. You can pull that self-respect and self-esteem back to the present by recognizing that you are on the path to being rich.
Planting a tree
I like to think of investing timeframes like planting trees. Warren Buffet said, “Someone is sitting in the shade today because someone planted a tree a long time ago.”
I remember my grandfather watering a chestnut tree sapling. Chestnut trees are exceptionally long lived. Ones in Europe are reported to reach over 1,000 years old. The natural life expectancy is in the range of 200–800 years.
Start to envision the wealth you are now creating as a legacy. It’s not just for you. It will allow you to make your life infinitely more fun, interesting and exciting. But you can also structure foundations and inheritance. Your legacy can be like a chestnut tree, or a forest of them.
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