Generally speaking, when it comes to meeting your future financial objectives, you’ll need three things: time, discipline, and knowledge. Interestingly, most people believe the most important of those three is knowledge, when in fact it is undoubtedly time. The more time you have to meet your financial goals, the easier they will be to attain. The less time you have to meet your financial goals, the harder they will be to attain. A little bit of knowledge, an ounce of discipline, and a whole lot of time can accomplish just about any financial objective.
Compound InterestCompound interest should be the nucleus of every investor’s plan for financial freedom. What is compound interest? Well, first let’s make sure we understand what interest is. Suppose you had $100 invested into an account that paid you 5% at the end of the year. How much would you have at the end of that year? Many of you can eyeball that, and quickly come up with $105. But, how do you arrive at that number in a more formal setup?
Multiply your initial investment by 1.05 (.05 being 5%): $100 (1.05) = $105
So, at the end of the first year, you’re sitting with $105 in your account. $100 of that is from your original investment, and $5 is the interest you earned on that original investment.
To understand what compound interest is, let’s look closely at how this same account would grow from year one to year two, if we assume another 5% interest rate: $105(1.05) = $110.25
This second year, you earned $5.25 on your investment. Not only did you earn another $5 in interest, the 5% on your original investment (the $100), but you also earned an additional $0.25 in interest, which is 5% of the interest you earned in the first year (the $5.) This interest earned on previously earned interest is what is known as compound interest. Now, an extra $0.25 may not seem too worthwhile to get excited about. Fair enough. However, while the first few years of compound interest may not be too impressive, if given enough time, the final few years of compound interest can be completely mind blowing.
Use the calculator above to see just how much compound interest can help you save for the future!
In fact, it is rumored that when asked by a reporter what the most powerful force in the universe is, Albert Einstein responded, “compound interest.”
Historically, stock investments have provided investors with higher returns than bonds or other "safer" investments, which makes sense because stocks are riskier investments than bonds. In other words, there is a positive relationship between risk and return. As a result, the younger you are, the more risk you want to assume because the higher returns associated with those risks are far more effective at building wealth. Your youth will allow you to weather any storms and stay invested in the market long enough to recover from any down years in the stock market.
The older you are, the less risk you want to assume because the time when you’ll need to access the funds you’ve spent a lifetime accumulating is getting closer and closer. You simply do not have enough time left to recover from any significant blows to the value of your portfolio.
In other words, someone who is 58 and about to retire, should have much less invested in stocks (and more in bonds) than someone who is 25 and starting to invest for their retirement thirty years down the road. A good rule of thumb is to take the following equation to determine what percentage of your portfolio should be invested in stocks: 110 – Your Age = % of Portfolio Invested in Stocks
For example, if you were 20 years old and just started investing, then you would invest 90% of your portfolio into stocks, with the remaining 10% invested in lower risk investments, like bonds. The idea here is that as you get closer and closer to retirement you will gradually shift your investment allocation from stocks (higher risk) to bonds (lower risk.) While the goal when you were younger was primarily wealth accumulation, the goal as you approach retirement becomes more about wealth preservation.
