Fundamentals 101 – Compound Interest
Have you ever heard of compound interest? Albert Enstien once said that compound interest is the 8th wonder in the world.
If someone so smart makes that statement, there must be something for us to know about it. In this article, we will explore what compound interest is and how you can take advantage of it.
But first, if you were given a choice of getting RM1 million right now, or 1sen today, have it doubled every day for 30 days, which would you choose?
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What is compound interest
Before we get to compound interest, let's break down the two different words.
Compound means to grow on itself. A good metaphor would be a snowball. A snowball might start off really small, but as you roll it in more and more snow, the snowball suddenly gets a lot bigger.
Interest means the money the money you get from loaning money to some entity.
So compound interest means instead of taking out that money that you make, you put it right back into the loan / investment and have it make you more money.
This would be like your money making baby money and having that baby money make you more baby money.
Eventually, the goal is that the compounding of the interest gets so big that it can replace your work income, allowing you to do something you love with your time.
What is a good compound interest to aim for
Although there are no specific compound interest goals set out there, the US stock market (S&P 500) has had an annual compounded growth rate (CAGR) of close to 10%. This means that $1000 put in in 1990 would be worth almost $17,500 in 2020.
That said, if you can get 8%, and you're still in your 30s, you will have more than enough to survive once you retire.
Different ways to get compound interest to work for you
At the end of the day, the idea of compound interest is to take all the money you get from the investment and reinvest it back in. That means not spending any of the money or profits.
That said, the best way to get compound interest in Malaysia to work for you is to put your money in investments that have a long track record of giving you a specific interest rate (or CAGR).
The easiest way is to buy into a stock market index like the S&P 500 (you can do that via Rakuten Trade) or buy into a unit trust that has at least 10 years of track record (that way you can ask for the CAGR of that unit trust).
Compound interest calculator in Malaysia
Use this calculator to see what types of returns you can get by simply finding a way to increase your compounded growth by 1-2% or increase the number of years.
The reason why you should start early
Compound interest is the reason why people always say they wish they have invested earlier (because then you increase the number of years the compounding can work for you).
But instead of hearing it from us, here's a simple picture of what happens if you were to invest now compared to waiting.
As you can see, the person who invested for the first 10 years and stops after still has more money than the person who starts 10 years later but invests for 20 years. This is the power of letting time work for you.
What should you do with this information
Now that you know what compound interest is, what should you do with that information? Even though we just talked about starting early, we do not believe you should be investing the money you have right now in some stock or bond for compound interest right now.
Instead, we suggest you invest that money in the best investment you can make as that will give you a much higher return in the next 3 years and then take all that extra money you make to start investing in compound interest.