Depending on your location, as April comes to a close you may just be starting to enjoy the spring weather. After all: April showers bring May flowers. That’s because nature knows how to invest. You get nice spring rains and only a month later do you get the peak bloom. If the rainy season were in May, the flowers wouldn’t come until June. This is a key lesson for investors: don’t wait to invest. Not only do you have to leave time, but the earlier you start, the more money you’ll make.
Compound Interest: The Rewards of Starting Early
When you save or invest your money, you earn interest. But what really makes it worth investing ASAP isn’t the interest, it’s the compound interest. Compound interest is the interest you earn on the interest. Let’s look at some examples:
Simple Interest
Let’s say you invested $100 and expect to earn %5 interest annually. At the end of one year, you’ve got $105. Now let’s say you put that extra $5 in your wallet and reinvest the original $100. At the end of year two, you’ll have another $105 in your portfolio. Now you put another $5 in your wallet and reinvest the $100. If you do this for ten years, you’ll have a total of $150.
Compound Interest
Now let’s say that instead of taking out the $5 you made after one year, you reinvested it along with the original $100. You’ll be earning %5 interest on $105 instead of just $100. So in year two, you’ll make an extra $5.25 instead of just $5. You’re already $0.25 ahead. Over ten years, here’s how that would play out:
Original investment: $100
End of Year 1: $105
End of Year 2: $110.25
End of Year 3: $115.76
End of Year 4: $121.55
End of Year 5: $127.63
End of Year 6: $134.01
End of Year 7: $140.71
End of Year 8: $147.75
End of Year 9: $155.13
End of Year 10: $162.89
Relative to the principle you invested, that’s nearly 13% more. But in either case, there’s a clear logic to investing earlier. Even in the case of simple interest, if you started investing five years later, you’d have $25 less at the end. But for most people, it’s not that they don’t know this. A lot of investors are waiting until they have a more sizable amount to invest. Whether or not it’s the best financial decision, people tend to hold off. But for most people, that is a mistake.
Why Wait to Invest?
Let’s run the numbers again. But this time, by waiting five years, you’ll be able to invest $130 instead of your $100.
Investment in Year 6: $130
End of Year 6: $136.50
End of Year 7: $143.33
End of Year 8: $150.49
End of Year 9: $158.01
End of Year 10: $165.92
You’re actually making more! But that’s only part of the story. The question is, what were you doing with that $100 throughout the first five years? Did those $100 enable you to make the extra $30? If so, then it’s not that you waited to invest, it’s that you invested in something else: perhaps you used it as capital to open or expand a business. Perhaps you used it to live on while you took time off to go back to school, enabling you to get a higher salary afterward. But maybe you were just waiting until you had a bigger chunk to invest. But investing small chunks as they come would have been a better move, as we’ll see here:
Original investment: $100
End of Year 1: $105
End of Year 2: $110.25
End of Year 3: $115.76
End of Year 4: $121.55
End of Year 5: $127.63 + $30 you just got and added to your investments = $157.63
End of Year 6: $165.51
End of Year 7: $173.79
End of Year 8: $182.48
End of Year 9: $191.60
End of Year 10: $201.18
$25 more than if you waited for the big chunk! So the conclusion is that there are no hard and fast rules when it comes to your finances but when you’re making your financial plan, don’t discount the importance of compound interest. And whatever you plan to do with your money, get it started!
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