I received $100 recently for some side work that I did last month. That sounds a bit cryptic; I officiated a wedding. It's not something I do regularly anymore, but I enjoyed the opportunity to marry some friends.
As most of us do with money we receive outside of our paychecks, I spent some time thinking about what I should spend it on. Many things came to mind, but the one purchase I've been wanting to make as of late is for a set of Bose speakers for our house with bluetooth and all that good stuff.
I lived in that world of wondering how the sound would be in our home for a bit when I got curious about another way to use the money. What if, instead of spending it, I invested it? What would happen to $100 if I just threw it in an index fund (a fund basically mirrors one of the many indices out there, like the S&P 500) and didn't touch it until retirement, say 30 years from now?
For the sake of simplicity, let's say that the index fund I invest that money grows at around 8% annually for 30 years. Using this simple calculator I learn that if all I did was put this money in a fund for 30 years it would grow to $1,006.27. I know, it doesn't seem like much, especially taking into account inflation and, well, 30 years of it just sitting there.
Let's use a different example. Let's say you spend around $300 a month eating out. That's a fairly reasonable amount for many of you, especially the single folk who don't be cookin'. Let's say you are looking to start budgeting and getting right with your dough. You're actually blown away when you realize you spend that much on eating out, going to bars, etc. and reduce it to $100 a month, which is where we are at currently as a family of 3. What if you saved the $200 you're not spending and put it in the bank for a year. You have $2,400! Now, what if you took that as a starting balance for an index fund and put an additional $2,400 every year in that fund for the next 30 years?
Using the same numbers as above, guess how much money you'll have. You honestly have no idea and you're gonna freak out when you see the number.
Do you believe it?
This is an introduction to compound interest, a revolutionary concept that Einstein famously quipped is the "eighth wonder of the world" and Warren Buffet has said is one of the three main factors for his success (the other two being that he's lived a long time and that he's American).
Compound interest means that interest is being applied not only to the principle amount, but also to the interest that has accrued on top of that amount. For example, if I have a principle amount $1000 and it gets 10% interest compounded annually, at the end of year one I have $1100. But in year two the 10% isn't being applied only to the principle of $1000, but also to the $100 of interest already gained. That means at the end of year two I have $1,210. This kind of action happening over a long period of time has a massive impact on our funds.
The majority of us in American just don't get this. We haven't been taught the cost-benefit analysis through the lens of compound interest. Often it's the different between spending money here or there. Instead, we need to learn that spending money somewhere means we are losing the chance to save it elsewhere. We learn a lot about working for our money, but not enough about making our money work for us.
So the next time you are thinking about going out to eat or having a night out with friends, consider what that $50, $75, or $100 could really mean to you in 10, 20, or 30 years. Small choices like that can add up to making you hundreds of thousands of dollars or even a millionaire.