By Burton Malkiel and Charles Ellis
Rebalance Investment Advisory Board
Rebalance is an industry-leading retirement investment advisory firm that helps everyday Americans retire with more. Our world-renowned Investment Advisory Board members have published several ground-breaking books on retirement investing. To help you better understand the ins and outs of saving for retirement, we're including selected sections from several of their best-selling books here. Enjoy.
The Elements of Investing
The Power Of Compounding
The secret of getting rich slowly but surely is the miracle of compound interest. Albert Einstein is said to have described compound interest as the most powerful force in the universe. The concept simply involves earning a return not only on your original savings but also on the accumulated interest that you have earned on your past investment of your savings.
The secret of getting rich slowly, but surely,
is the miracle of compound interest.
Why is compounding so powerful? Let’s use the U.S. stock market as an example. Stocks have rewarded investors with an average return close to 10 percent a year over the past 100 years. Of course, returns do vary from year to year, sometimes by a lot, but to illustrate the concept, suppose they return exactly 10 percent each year. If you started with a $100 investment, your account would be worth $110 at the end of the first year – the original $100 plus the $10 that you earned. By leaving the $10 earned in the first year reinvested, you start year two with $110 and earn $11, leaving your stake at the end of the second year at $121. In year three you earn $12.10 and your account is now worth $133.10. Carrying the example out, at the end of 10 years you would have almost $260 – $60 more than if you had earned only $10 per year in “simple” interest. Compounding is powerful!
Do you know the amazing Rule of 72? If not, learn it now and remember it forever. It’s easy, and it unlocks the mystery of compounding. Here it is: X × Y = 72. That is, X (the number of years it takes to double your money) times Y (the percentage rate of return you earn on your money) equals… 72.
Let’s try an example: To double your money in 10 years, what rate of return do you need? The answer: 10 times X = 72, so X = 7.2 percent.
Another way to use the rule is to divide any percentage return into 72 to find how long it takes to double your money. Example: At 8 percent, how long does it take to double your money? Easy: nine years (72 divided by 8 = 9).
Try one more: at 3 percent, how long to double your money? Answer: 24 years (72 divided by 3 = 24).
Now try it try it the other way: If someone tells you a particular investment should double in four years, what rate of return each and every year is he promising?
Answer: 18 percent (72 divided by 4 = 18).
For anyone whose attention is attracted by the Rule of 72, the obvious follow-on is surely compelling: If a 10 percent rate of return will double your money in 7.2 years, it will double your money again in the next 7.2 years. In less than 15 years (14.4 years to be exact), you’ll have four times your money – and sixteen times your money in 28.8 years.
