I love compound interest, especially in the stock market. It allows me to set aside savings that can appreciate without any extra work on my end. If the stock pays a growing dividend, I can earn a growing stream of income year after year, depositing it into my bank account. What could be better than that?
The key to the stock market is compound interest. Over 10 years (or even much longer), this is the best wealth builder, helping you build a nest egg for retirement or whatever your goals are. Compound interest is magic, and anyone can implement it with their retirement savings by investing in the stock market. Here’s how.
What is compound interest?
Almost everyone will know how interest income works. You may have a bond, certificate of deposit, or any other savings account that pays you a percentage on your savings every year, perhaps at a fixed rate every period.
Compound interest is when the interest rate compounds on itself, delivering ever-increasing returns over decades. This is how stock market appreciation works. When buying a stock, the compound growth rate — say, 10% a year — means that the 10% growth is applied to your current level of wealth, which is why it is considered to “compound” on itself over the long haul.
An initial investment of $10,000 that generates 10% in compound annual returns would deliver $1,000 in gains in year one. By year two, this figure would grow to $1,100 because you are applying the 10% rate to your current investment of $11,000 ($10,000 + the $1,000 in gains from last year’s returns). Over 20 years, this simple 10% compound annual growth rate would turn $10,000 into over $67,000 just by sitting tight and letting the magic of compound growth work.
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Compound interest versus basic income
Compound interest is magic compared to simple interest, as the example above illustrates. A simple $1,000 in interest income earned every year on a $10,000 investment would grow to $30,000 ($10,000 + 20 years of $1,000 payments), which is less than half of what you’d get if you just let the investment compound.
When you buy “passive” income assets in real life, such as real estate, you can earn rental income that may grow along with inflation. However, it involves a lot of real-world work, such as dealing with tenants, maintenance, and regulations. Buying a home may lead to some value appreciation over the long term, but house prices generally just follow inflation and pay you no earnings along the way, along with major maintenance expenditures. You are betting on a lump sum when you finally decide to sell 30 years later.
Conversely, compound interest in the stock market requires no physical labor. All you have to do is open up a brokerage account and begin adding some stocks or index funds to your portfolio.
How to optimize compound interest in your portfolio
I think investors can maximize compound interest by lengthening their time horizons and minimizing their tax bills.
Sometimes you may have a short-term goal in mind for your savings, such as buying a home. But most of the time, your savings are a vehicle for financial independence for yourself, your family, your heirs, and maybe even some charities on a perpetual time horizon. Therefore, the best mindset is to say, “I am going to buy and hold stocks for my entire life.”
Minimizing taxes involves proper use of retirement accounts such as an IRA, a Roth IRA, and a 401(k). You can also minimize taxes by reducing your trading activity and delaying capital gains distributions.
Do this over a lifetime, and you will be shocked at how much wealth and financial independence you have built up. If you contribute just $10,000 a year for 50 years to your savings, which compound at 10% a year, you will end up with just under $13 million. That is the incredible power of compound interest that I love about the stock market, and you should as well.
