Recently, I was discussing the concept of compound interest with a new client. Compounding, or compound interest, is rather complex. Basically, it explains how your investment grows over time because of the interest earned on both your principal and the accumulated interest.
There is an urban legend that Albert Einstein once declared compound interest to be “the most powerful force in the universe.” I’m not sure if Einstein actually said it or not, but the wisdom is still sound.
Which is the better deal?
So here is a question: would you rather have $1 million today, or one penny that doubles every day for 30 days? Most people (about 90% actually), would take the $1 million. But if you did, you’d actually have just lost over $4 million. Yup, that one penny would become $5,358,709.12 in just 30 days. The simple act of doubling your previous day’s investment can reap huge rewards thanks to compounding. Now, finding an investment that doubles consistently is virtually impossible, but the premise is still solid.
A question we get almost weekly is, when is the best time to invest? My standard answer is 10 years ago. I say this only half joking. Rather than worrying about ‘is the market ripe for a downturn’ or the latest political ‘tweets,’ it is time in the market that is key, not timing in the market.
A tale of two brothers
There is a powerful story I wish I was taught in school, but sadly is not. It’s the tale of two brothers. The first brother starts investing at age 22, into a tax deferred account (RRSP) earning 10% annually. He invests $5,500 a year until age 29. Then he stops investing. So a total of only 8 years, and the total contribution is $44,000. At age 65, the first brother would have $2,105,640.
The second brother decided he too will invest, but he waits until age 29. He invests $5,500 a year into an RRSP also earning 10% annually, but he continues to invest until age 65. His total contribution is $203,500, substantially more investment than his brother and for a longer period of time. However, his contributions only grows to be worth $1,979,758 at age 65. Why? Compounding!
The tale improved?
The above tale is a powerful illustration of the power of compound interest. But I have often wondered how much better the first brother could have done. I see two ways to improve. The first is, why did he stop investing after 8 years? If he continued even at a modest amount, the end result would have been multiples higher.
Second, what isn’t discussed is what happens next. RRSPs are great and they do have their place, but what if the brothers put their money into a tax-free savings account (TFSA) earning the same 10% annual return? Then the above amounts would have been tax-free.
This article is part of a monthly series of investment and insurance advice featured in Hespeler Village Magazine. The write of these articles, David Reeve, is President of Davlyn Financial a local, award-winning financial planning firm in Cambridge.