Financial 'Maths': How Early Investing Pays Off

Hi Reader,

Welcome to The Money Series and if you are new here, thank you for signing up. Personal Finance can feel ambiguous and overwhelming, but I am here to help simplify the journey.

I received some interesting questions after last week’s newsletter, prompting me to revisit the basics of investing. Always remember that if something isn’t clear, you can ask questions and I will clarify.

Today’s newsletter contains many numbers. It’s quite interesting but requires your full attention to grasp the concepts and understand the figures.

Understanding Simple and Compound Interest

Simple interest (in the investing sense) is simply a regular interest earned on a lump sum amount over time. For example, if you invest $1,000 at a 10% interest rate for 5 years, the interest earned each year will be $100 ($1,000*10%). Over 5 years, that totals $500 in interest, resulting in a total amount (principal + interest) of $1,500, as shown below:

This is typical of a loan scenario - if you lend someone money for an annual interest rate. The borrower pays a fixed rate and amount and the principal is borrowed at the end of the period.

Now let’s look at Compound interest. Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the principal amount plus any interest previously earned. This results in interest being earned on interest, significantly increasing the total interest over time. In the $1,000 investment amount example, the interest in the first year will be $100 ($1,000*10%). By the end of the first year, the total amount in the account will be $1,100 ($1,000 invested + $100 interest earned) and interest will now be earned on the total amount of $1,100 and not just the initial investment of $1,000. Below is a breakdown of how this investment will pan out over 5 years.

At the end of 5 years, the total amount in the account becomes $1,610.51, which is $110.51 higher than with simple interest due to the effect of compounding. This effect becomes more pronounced for higher amounts and over longer periods.

The Magic of Starting Early

Consider two friends, Greg and Abel, who are the same age. Greg started investing in the S&P 500 index* at age 21, contributing $200 monthly for 20 years, then stopped but left his money invested until he retired at 60. Abel did the same but started investing 10 years later at age 31. Let’s look at the differences in their wealth at age 60**.

The effect of compound interest is obvious in the total investment value for Greg at 41 and Abel at 51 because they contributed a total of $48,000 and had more at the end of the contribution period. The compounding effect is also evident in their wealth at retirement.

Greg’s early start allowed his investments to compound significantly, leading to over $1 million at retirement. Abel’s later start resulted in a significantly lower amount due to fewer years of compounding.  

Starting earlier by 10 years made Greg retire with three times the amount of Abel’s wealth.

Key things to note:

• Start early and be consistent. Automate your savings and investments to ensure consistency.

• Invest for the long-term. Don’t try to time the market. Invest the money you won’t need for at least 5 years to allow for market fluctuations and growth.

• Diversify your investments. Don’t put all your eggs in one basket. We will discuss this further in future newsletters.

Before you start investing, ensure you have:

• An emergency fund covering at least 3-6 months of your living expenses

• Paid off all interest-paying debts. You want to avoid paying more interest on the debt than you are earning on your investments.

Two key takeaways:

• Starting early + the power of compounding = building lasting wealth

• Compound interest is the eighth wonder of the world. He who understands, it earns it, he who doesn’t‎, pays it - Albert Einstein

Feel free to send in your questions; they might influence the next newsletter!

Act Now:

• If you haven’t started already, set up an investment account today

Reflect on This:

• Considering your planned retirement date, how many more years will you be able to invest?

Till next week, I am rooting for you, money-ly!

Dee

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*The S&P 500 index also known as the Standard & Poor's 500, is a stock market index that measures the stock performance of 500 of the largest companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices and is often considered a benchmark for the overall health of the U.S. stock market and economy.

** This assumes that all dividends are reinvested in the index and that no withdrawals were made.

Disclaimer: This does not constitute financial advice. Please conduct your research or consult your financial advisor for important financial advice.