By Dr. Andrew C. Schaffer, J.D., M.B.A.
"Compound interest is the 8th wonder of the world."
"…whoever gathers money little by little makes it grow."
Proverbs 13:11 (NIV)
One of the core keys to financial success is saving and investing money… and saving it and investing it early.
In Chicago, there is a saying, due to corruption in politics: "Vote early and often." To summarize this article, "Save and invest early and often."
Most of the students I teach are amazed at the difference just a few years of savings can make. Let's start off with an analogy.
The Compounding Snowman
Some of you have probably built a snowman in the front yard. The base of the snowman is the hardest part. You start off with a small ball, and roll it over and over and over again across the lawn. You might roll it 10 times. At the end, it might be soccer ball sized or a little bigger. Then you turn it around facing fresh snow, and roll it just one more time, and it grows in size a bit. In just one or two more rolls, you have to get help to push it just one more complete turn, because of all the snow added in that last roll. You can learn more about the wealth compounding "snowball effect" here.
Compound interest is like that. It is interest upon interest upon interest. And the first 10 to 15 years, it grows gradually. But then, it starts to grow much faster with each passing year.
Example of Math Behind Compounding
Here is an example:
If you have $10,000 and earn 7% each year, you will have in one year, $10,700. (7% of $10,000 is $700). But in two years you will have $11,449, instead of just $11,400.
The reason is the $700 earned the first year also earns 7% and thus you have an additional $49. It isn't a lot of money…yet.
But check out what happens in 10, 20, 30 and 40 years: $10,000 grows to:
- 10 years: $19,672
- 20 years: $38,697
- 30 years: $76,123
- 40 years: $149,745
At 7% growth, it takes about 10 years from the start, to (almost) double your money, from $10,000 to $19,672, at 7% per year.
But look what happens after that - Note that the time to earn each successive $10,000 is shorter and shorter and shorter.
In fact, after Year 40, at 7% interest, you would earn an amount greater than the original investment ($10,000) in interest in just one year. That is the power of compound interest. It is amazing.
Dividend Investing & Compounding
What does this have to do with Dividend Investing? Everything.
Dividends on average are paid (currently) at a rate of about 2% per year on stocks. While dividends are not guaranteed, they are often and usually paid, especially by firms that are larger, and have a history of paying them regularly.
These are the types of stocks that Ben regularly recommends in his newsletter. So, if you invest in dividend paying stocks, and those stocks only grow in price 5% per year on average, you would still have a 7% total return (5% from price appreciation of the stocks, + 2% from dividends paid.)
Otherwise, you have to hope that a non-dividend paying stock will appreciate at least at a 7% rate per year, just to keep up with the dividend paying stock's overall return.
Importance to Millennials
Why is this important to Millennials?
A recent study showed that only 24% of Millennials had basic financial knowledge. Millennials include those born between the early 1980's and mid-1990's.
While budgeting is understood my most Millennials, concepts such as diversification and investing are not as well known.
Dividend Investing means buying several stocks (more than 10 most of the time) that pay dividends. This way, if one company fails or does badly, you are insulated from disaster hitting all of your investment, since most of it is in other stocks. That is the benefit that diversification brings.
A famous line is, "Don't put all your eggs in one basket." That is exactly what diversification does… it is an investment strategy of buying several stocks, so that if one goes bad, the others insulate you from greater financial harm.
Example of Diversification
Here is a brief example: Assume you bought 50 shares of Apple, Inc. (NASDAQ:AAPL) for $100 per share. That is a total investment of $5,000. (50 shares x $100 per share = $5,000.) If Apple has a bad run, the price might go down to $30 per share… a loss of 40%. (Apple actually did go down more than 40% between August 2012 and June, 2013.) Your $5,000 would have shrunk to $3,000.
But what if you took that same $5,000 and invested it in 9 dividend paying stocks, plus Apple. Thus you would have invested $500 each in 10 stocks. Between August 2012 and June 2013, if those 9 dividend paying stocks performed as the overall stock market, you would have made about 14% on them.
Of course, Apple still declined 40%. So, in Apple, your $500 would have gone down to $300. But your other $4,500 would have grown to $5,130 and so net, you would be almost even… with $4,930 -- a loss of only $70 total, instead of a loss in Apple of $2,000.
Dividends in stocks are extremely powerful because they add to returns, mitigate losses, and provide protection through diversification from the risk of investing in a single stock.