In 1985, the rock band Dire Straits released a song called "Money for Nothing." The song title was referring to the music business, but it aptly describes the shadier corners of the American economy. If you browse the Internet long enough, you inevitably stumble across various get-rich-quick schemes promising big money for little effort: investing in penny stocks, working from home, flipping houses, joining multi-level marketing programs, and so on. People who fall for such schemes find out quickly that the promised riches are just mirages that evaporate upon closer inspection.
Money for nothing doesn't exist, but something does come close: generating money through compound interest. One of the most common ways investors generate compound interest is by investing in a diversified portfolio of ingredients from the financial markets: stocks, bonds, real estate, and commodities. Compound interest, as you might remember from high school math class, is interest earned on an amount of money that was borrowed or invested (the principal) plus the interest already earned. Compound interest differs from simple interest, which provides a fixed rate of interest on the original amount.
Math teachers often illustrate the amazing power of compound interest with the old metaphor of the magic penny. The scenario goes like this: suppose someone offers you a choice of getting 1 million dollars at the end of the month or getting a magic penny that doubles every day. Mathematically naïve people will chose the million dollars, but as you've probably guessed, the magic penny ultimately generates more income after 30 days. You'll have two cents on the second day, four cents on the third, eight cents on the fourth day, and so on until you reach $5,368,709.12 on the 13th day. If you carry out the calculations yourself, you'll see that the numbers are pretty puny for the first few days, but in some weird inexplicable way, the numbers reach staggering sums after a few weeks.
This example gets the point across well, but earning that kind of return in the financial markets in real life is unlikely. Let's take a more realistic example. If you invest, say, $100 with a return of 10 percent simple interest for 20 years, you'll earn $10 per year during that time period. After the first year, you'll have $110, at the second year, you'll have $120, and so on. The rate of interest never changes, so you'll ultimately have $300 after 10 years (the original $100 plus $200 earned in interest). No surprises there.
On the other hand, suppose you earn 10 percent compound interest on your investments -- what a difference that word makes. The first year, you earn the same amount: $110. The second year, however, you earn ten percent on the $110, so your money is now $121. The third year, you're earning 10 percent on the $121. This all adds up to trivial amounts of money in the few first few years, but as time goes on, the amounts really start to pile up. At year seven, you've nearly doubled your money, and at the end of the twenty year period, you end up with $672.75. If you plot these numbers on a graph, you'll see that the line gets steeper as you go along, soaring upward like a rocket, which means that your money increases at a faster rate as time passes.
So how does that affect you? If you invest your money in stocks and certain types of bonds (e.g. Zero-coupon Bonds or Series EE Savings Bonds), your money earns compound interest, not simple interest. You can also magnify the power of compound interest by investing in a mutual fund that offers a DRIP (Dividend Reinvestment Plan) that channels your earnings back into the mutual fund, thereby increasing the amount of money accruing interest. And the longer your money stays invested, the more interest it will accrue.
There are two big lessons here: First, start investing as early as you can, so that your money has a longer period to grow, and secondly, put the money in and leave it! Don't take money out of an investment account unless you're faced with a genuine emergency, because if you remove that money, you're depriving it of a chance to accumulate interest.
In the example given above, we looked at hypothetical investment of $100 with an interest rate of 10 percent. I chose this example not just because ten is nice round number that's easy to add and multiply, but because the American stock market has historically produced about a 10 percent return on investments over the long term on average. Let me emphasize "on average:" the rate of return will vary year in and year out, and the stock market rarely returns exactly 10 percent in any given year. In any case, though, such a rate of return is feasible.
Cool! Compound interest sure is great! So why isn't everyone in America a millionaire? Well, like everything in America, there are catches. If you've followed the financial markets at all, then you've seen that they don't simply climb higher and higher eternally: instead, they fluctuate along with the economy. In the long run, the general trend arcs upward, but in the short term, it's more like a natural landscape full of peaks and valleys. In order to fully realize the benefits of compounding, you have to develop the stomach to ride out the downturns and stick to your plan. You must resist the temptation to panic and sell off your assets when the markets turn sour.
Another force working against you (as I've mentioned elsewhere) is inflation, the tendency of your money to lose value over time. If inflation averages around, say, three percent a year, then that 10 percent rate of return on your stock portfolio will have a real rate of return of only seven percent.
Above all, you need to keep in mind that risk and return go hand-in-hand: the riskier the investment, the higher the potential rate of return. This is why you need to diversify by investing in bonds, money market accounts, certificates of deposit, and a wide array of stocks. By doing so, you spread out your risk and buffer your wealth against the worst shocks of the market.
The effects of compounding show that money is not a static substance; it's a dynamic force that has the power to grow and multiply if used intelligently, or to wither and fade if it isn't.