Power of compound interest: Time is ‘one of your biggest allies’
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Key takeaways:
- Start early and invest what you can, even if only investing small amounts.
- If starting later in your career, be more aggressive with the savings rate to make up the lost compound interest time.
When investing, time in the market is arguably as important as well-publicized factors, such as rate of return, initial amount of investment (principal) and costs of investing. This is largely due to compound interest.
Compound interest refers to the snowball effect of interest earning interest. Because interest accumulates on returns, as well as principal, one’s portfolio grows at an accelerating rate over time.
To best illustrate the power of compound interest, let us assume one invests $25,000 at a 5% annual rate of return at age 30 years old. How does that principal grow with compound interest?
- 40 years old: $40,722.37
- 50 years old: $66,332.44
- 60 years old: $108,048.56
Let’s tackle a more realistic scenario. You decide to invest $25,000 at a 5% annual rate of return at age 35 years old. In addition, you invest $2,000 from each monthly paycheck. Here is what your portfolio looks like at each decade of life:
- 45 years old: $265,000 contributed, $342.591.79 total value
- 55 years old: $505,000 contributed, $859,915.34 total value
- 65 years old: $745,000 contributed, $1,702,580.90 total value
Notice how the growth in net worth is nearly $900,000 between ages 55 and 65 years even though the amount contributed in that decade is the same $240,000 as the prior decade.
Compare this with the physician who decides to “catch up,” so to speak, by entering the market at age 45 years by putting $25,000 at a 5% annual rate of return. In addition, she decides to invest $4,000 from each monthly paycheck to try and catch up:
- 55 years old: $505,000 contributed, $644,461,21 total value
- 65 years old: $985,000 contributed, $1,653,498.24 total value
Despite contributing more than the prior example, this surgeon is still short from a net worth perspective, as she did not benefit from compound interest to the same extent.
Time in the market is one of your biggest allies. Start early and invest what you can, even if you are only investing small amounts. If you start investing later in your career, fear not — you can still win the game. But you will need to be more aggressive with your savings rate to make up the lost compound interest time.
For more information:
Chirag P. Shah, MD, MPH, is a soccer and Nordic ski coach, who also practices medicine and teaches in Boston. He can be reached at cshah@post.harvard.edu.
Jayanth Sridhar, MD, is an award-winning podcaster, physician and educator who is chief of ophthalmology at Olive View Medical Center in Los Angeles. He can be reached at jsridhar119@gmail.com.
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