Albert Einstein is quoted as saying, "The most powerful force in the universe is compound interest." When someone as brilliant as Big Al talks about the power of compounding, I don't know about you, but I tend to listen!

Well, here's another smart guy, this time from Kiplinger's, who says, "Time is the most powerful weapon in an investor's arsenal. Nothing comes close to it." Why? Because of the power of compounding. Here are some of his key thoughts:

**After 30 years of studying finance, I have found few eternal truths, but the most important -- the Golden Rule of Accumulation -- is this: Start early!****Time is the most powerful weapon in an investor's arsenal. Nothing comes close to it.****Let's do the numbers. The annualized return for U.S. large-company stocks (as represented by Standard & Poor's 500-stock index) for the past 80 years has been about 10%, not including taxes. Say your goal is to build a nest egg of $1 million by the time you are 55. If you start at age 24 and invest $5,000 a year at an annualized return of 10%, you'll reach your goal. But if you wait until you are 34 to start, you'll accumulate only $357,000 by age 55. If you start at age 44, you'll have just $107,000.****How can this be? The answer lies in compounding, the fact that interest increases the value of interest as well as the value of principal. If you earn 5% on $1,000, after a year you'll have $1,050. After two years, you'll have not $1,100 but $1,102.50.****As time passes, the power of compounding accelerates dramatically.****One other important fact about compounding is that a small increase in the rate of return can produce a huge impact over time. In the case of the gift to your newborn daughter, if her portfolio returns 10% annually, then $10,000 grows to $4.5 million by the time she is 65. But if her portfolio returns 8%, then it grows to only $1.4 million. If it returns 5%, it grows to a mere $227,000. In other words, half the rate of return produces an account that's less than one-twentieth the size.**

The article then ends with this conclusion:

**But enough numbers. If you're a young person, all you need to know is that you must start early. If you are an older person who has young progeny or young friends, encourage them to start early. If you're particularly generous, set up a long-term trust or a Section 529 tax-advantaged college savings plan, or simply open a mutual fund account that the young person promises not to touch (or perhaps doesn't know anything about).**

The piece then goes on to talk about where to invest your money. Me? I like index funds.

Just a great overall summary of one of the pillars of growing your net worth. Every person needs to know, understand, and apply this financial wisdom to make the most of their finances. I've been doing it for 15 years or so now and the power of compound interest is still really starting to take off -- it's really making a strong impact on my net worth. I can't wait to see what it does over the next 20 years!!!!

One of my favorite quotes about taking action is this:

**The best time to plant a tree is twenty years ago. The second best time is now.**

If you've lost a lot of investing time because you've procrastinated, just didn't know what to do, didn't have the willpower to save, weren't able to save, or whatever reason you might come up with -- stop fretting about it. It's water under the bridge. There's nothing you can do to get back that lost time. But you can still make a difference in your finances. How? Start saving today! 20 years from now, you'll be glad you did. ;-)

For more on the topic of compounding, see:

A blog after my own heart. This topic was my very first blog entry.

A couple of important things to note:

(1) Albert Einstein discovered the rule of 72

(2) Albert Einstein said this discovery was his single best discovery.

Rule of 72: Divide 72 by your investment rate of return or the interest rate on your debt and you'll get the number of years it'll take for either to double.

Posted by: Finance Junkie | April 20, 2006 at 04:04 PM

Here's some more fun math:

Say a kid got a 'great' paying job for a 20 year old at 45k anually...but he actually lived on the same 15k a year that the kid going to med school survived on...and let's say the 20 year old that skipped med school for the 'great' paying job invested the remaining 30k of his salary into stocks.

Here are the facts...

The med-school student graduates 'on time' at the age of 28; secures a job paying 150k a year and pays all of his debts off by the age of 33---so theoretically he's 33 before he actually has an effective salary of 150k.

The kid that skipped med-school and invested in stocks earned the historical average of 10.1% annually on his money (10.1% since 1926...but if you skip the Great Depression years the average is actually closer to 13%)

So where is this same kid at the age of 33?

He has $920,180 dollars in compounding assets. Coupled with his 45k annual salary he will earn 135k at age 33 while the doctor earned 125k.

The doctor cannot mathematically catch up up to the scrub who's still at his 45k a year gig...because after 13 years the scrub has about 122k to reinvest in the market that year while the doctor couldn't match that unless he lived on 3k for the year.

(What's the lesson? Understanding financing makes you wealth...and salaries are overrated.)

But none of this really happens, does it? The kid doesn't invest and the doctor stays in debt...

It's amazing they don't teach real-life economics in school:)

Posted by: Dan - Mortgage Loan | October 13, 2006 at 07:49 PM

p.s. pardon the error in the first paragraph where I gave the doctor a starting salary of 150k instead of 125k.

Posted by: Dan - Mortgage Loan | October 13, 2006 at 07:51 PM

Please don't perpetuate the Einstein quote theory. There's no proof:

http://timpanogos.wordpress.com/2006/07/22/einstein-compound-interest-does-not-compute/

Posted by: Darrell | April 04, 2007 at 06:59 PM

But by all means do keep spreading the word about the value of compound interest and the Rule of 72 -- just because Einstein didn't say it doesn't remove the value.

But, wouldn't it be great to know who really did say it?

Posted by: Ed Darrell | April 17, 2007 at 09:58 AM

Many people use the 10% for their long term interest examples, but how many of us actually yield 10% on our investments over the space of 10, 20, even 30 years? I personally know several men who have averaged 10% in investment real estate over the course of their career, but I've yet to hear I'd like to hear many people comment on their personal retirement portfolios.

Do 10% retirement yield exist anywhere besides such examples? Please show me, I want to believe!

Posted by: Bart | January 29, 2008 at 12:48 AM

This is a very good post, including the comments.

It's hard to overemphasize the iportance of having a good understanding of the time value of money (TVM). Everyone should understand the TVM but it's especially important for investors to grasp this concept.

Understanding the TVM is so important that I firmly believe that no one should be awarded a high school diploma without first demonstrating that they have a basic understanding of the TVM. Unfortunately, this is something that has always been lacking from most high school curricula. I say it's time for that to change.

Posted by: Mike - Investing in Mutual Funds | February 01, 2008 at 02:13 PM

From my calculations investing $30000 per year for 13 years at 10.1% ends up with $740,582 worth of assets and not $920,180. Correct me if Im wrong !

Posted by: Marco | August 27, 2009 at 07:35 AM

Marco --

I get that too. I think maybe he used 13% above?

Posted by: FMF | August 27, 2009 at 07:57 AM

$30000 per year for 13 years at 13% ends up at $899,541. Using my Hp 12c calculator ! To arrive at $920,180, interest would need to be 13.34%.

Posted by: Marco | August 27, 2009 at 09:34 PM