Albert Einstein once said that "compound interest is the eighth wonder of the world. He who understands it, earns is.. he who doesn't.. pays it."
The idea of earning between 3 and 4% interest on a savings account is mind-numbingly boring to even the most veteran of retirement planners and savers alike, but the concept of creating wealth through compound interest is one of the most dangerous weapons known to man.
As a 19 year old, I don't have much spare money to invest on the market, but when I do, even a huge 30% or 40% gain on a single stock amounts to a lower dollar value than what my grandparents earn on their 3% savings account.
So does this mean that I should just give up and wait until I have more money to play with? Absolutely not.
Below is a table showing how a relatively small amount of money, with the addition of regular savings and a modest annual growth rate, can become a goldmine when it's time to retire. The below figures are based on a starting value of $10,000, with $2,000 in annual savings being added at the end of the period. I chose a 10% annual growth rate because it is very similar to that of the long term average growth rate of the S&P 500 (NYSEARCA:SPY), which is the benchmark that every long term portfolio should be measured against.
The numbers are truly staggering; $110,000 ($10,000 + $2,000 x 50 years) of invested capital returns $3.5 million over a half century. The key ingredient is time. The market will average a return of around 10% over a very long period of time (9.8% between 1928 and 2014), all that's needed is an individual who is willing to endure the bad times, stay disciplined, and wait.
The power of compounding is evident when the numbers are analyzed; Between the years 13 and 14, the gain in the value of the portfolio is larger than the starting value of the entire fund, and over 50% of the final $3.5 million value is generated in only 7 years. Warren Buffett, who is widely regarded as the world's most successful and closely followed investor, gained over 99% of his wealth after his 50th birthday, which is staggering considering that 36 years later he's worth $71.9 billion according to Forbes.
The easiest way of achieving this level of growth is to steadily invest in an S&P 500 investment trust, much like the SPY, holding cash at times of panic for when everyone's a seller. "Be fearful when others are greedy, and greedy when others are fearful"- Warren Buffett.
However, I prefer to pick my own stocks. This method isn't for everyone, as it's riskier and involves more work, but I prefer to hold a selection of dividend stocks, and a few growth names, that I hope will beat the market.
This article is designed to show young investors that saving and investing even small amounts of regular money is definitely worth doing, and everyone should do this or similar. Saving $170 a month is equivalent to less than $6 a day, a realistic target for a young person in a full time job, and the potential reward for saving $2,000 a year is clear.
It is important to be careful; investing in safer investments when young I believe is crucial, because when compounded, any loss at a young age is huge when retirement is reached. There is a strong theory that making risky investments is better when younger, because a young person has their whole working life to make it back. Although this is true, losing $1,000 at age 21 knocks $117,390.85 off the value of the portfolio at age 71, assuming a 10% annual growth rate, which is why I believe that young investors should focus on safe dividend stocks that have bountiful yields, organic growth prospects and large moats to protect them from competitors. "It's better to buy a wonderful company at a fair price than a fair company at a wonderful price"- Buffett yet again.
The stock market does offer much more appealing growth than the average savings account, but with that comes greater risk. Just this year we have had a handful of days when the market has lost 2-3% in a single session, and even as much as 5% in the hours after Trump was elected President. Watching your money fall seemingly uncontrollably isn't for everyone, but this week the market is hovering around an all-time-high, meaning that every single sell off in history has been a buying opportunity for long term investors. When your favorite brand of baked beans is discounted at the store, do you run home and try to return what you have left, fearing even lower prices, or do you buy more than usual, happy that you have the same baked beans that you loved yesterday, but 5% cheaper? Of course, you buy the beans, and it's the same with the stock market.
Time is most certainly the most valuable of all commodities, so if you're young, use it as best you can to secure your financial future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.