Use the Force (of Compound Interest!)
Use the Force Young Money Jedi — the Force of compounding!
Around May the 4th, Star Wars Day, I like to remind myself of the power of long term compounding and wealth building. On a wealth building journey I believe it is vital to utilize this force. But what is the “force” and how can we use it build wealth?
Like a lot of folks out there, Jerry, Bob and I are huge Star Wars fans. We grew up playing with the cool action figures. Sure wish I had kept all of them, they would have made a wonderful long term investment! But now that we are grown up, there are other ways to use “the force.” As a money Jedi, we must continually seek ways to maximize investment returns, savings habits and use various Jedi mind tricks to build wealth. One of the most important, if not the most important force, is the force of compounding interest.
Simply put, the interest you make on your money makes more interest, and on and on as long as you do not touch it. In other words, do not chop down the apple tree, just continue to enjoy the apples. Use the force of compounding to increase wealth exponentially.
WHY IS THIS IMPORTANT
One of the great wonders of the financial and mathematical world, compounding! Of all the concepts discussed here, I personally believe this is the most important. The reason is that compound interest reinforces why small amounts of money invested consistently over time become large amounts!
We talk a lot about the secret force of compounding because it is the hidden mathematical force that anyone can harness to build wealth. It is not really a secret, but a lot of people just do not realize how powerful it can be in terms of helping you build wealth.
USE JEDI POWERS
Just like Luke Skywalker uses the force as a Jedi, you will want to use the force of compounding to grow your investments. It is so powerful that it must be embraced and understood to achieve financial freedom. It’s basically earning interest off your interest. It’s a feedback loop that adds to itself if you give it the magic ingredient of time.
So, let’s say you worked your butt off as an entry level stormtrooper for ten years, day in and day out toiling away to sustain the Empire. You were able to sock away that first $50,000 in your investment account. Here is the great news and the way to harness the force: The next $50,000 should be easier to achieve since you already have that initial amount in.
This is due to the “force” of compounding. Basically, each one of those $50,000 is now your mini storm trooper employee, working to spin off interest that is re-invested. But the real power is just beginning, because then each one of the new dollars starts working for you as well, and so on and so forth. In other words, continually reinvesting your gains leads to astronomical growth over time. Warren Buffett made many of his billions later in life by harnessing the power of compounding.
A simple example: Let’s say you invest $200/month in your index funds over the course of 20 years. This sounds like a long time, but it goes by faster than we think. At the end of that period you would have put $48,000 in that account, but through the power of compounding it could be worth over $100,000 at 7% interest. This is only 4% or less of a typical person’s salary. Ride this out for 30 years, a typical working time period and you end up with almost $250,000, a medium size fortune from a very small investment each month! The investments will continue to compound from here!
HOW TO HARNESS THE FORCE:
1. Save aggressively. To harness the power of the force, for the first 10 years, we must save, save, save, save, save and then save some more! This is because we need the initial amount to grow exponentially on itself. One can invest automatically in a low cost index fund every month and let the money be. Think of it as fenced off. This gives the compounding time to take effect. I also enjoy investing in Dividend Reinvestment Plans (DRIPS) and watching the dividends compound and become reinvested into additional shares. Those shares in turn make even more dividend contributions and so on and so forth.
2. Patience. The compounding effect really picks up speed later, during the time we call “critical mass”. This is what makes the rich richer. If you are in your 20’s, 30’s or 40’s, then there is time to make the nest egg build and fully harness the force of compounding.
3. Harness the spirit of compounding in your life. Each small act you take will build on itself and form into a healthy habit. Over time these “habits” compound into a powerful force. This is one reason we launched the 30 day Small Steps to Build Wealth Challenge.
Darth Vader Debt Will Use the Death Strangle Against You
BAD DEBT, THE DARK FORCE AGAINST COMPOUNDING
Debt! Most Debt! Bad Debt! It will choke your ability to grow and build wealth. Darth Vader uses compounding in reverse. It chokes off the ability of the investments to grow. Below are a couple rules to try and live by. Unfortunately I have made a few of these mistakes and am trying to make up for lost time. Because that is what this is about, giving our investments the time they need.
A. Do not borrow from your 401k if you don’t have too. I borrowed a few years ago to help buy my house. I live in an expensive area when it comes to real estate. I have since paid this back to my 401k. But I lost out on some compounding.
B. Avoid high interest debt and debt in general, this is compounding working against you. You are making someone else rich so you can be surrounded by a bunch of consumer junk you never needed to begin with.
Luke Skywalker and Leia Organa, go use the force that is free to you right now. All it really takes is having a percentage of our salaries stashed in low cost index funds and not touching them for 10, 20, 30 years. Be a strong Money Viking and pump those contributions to the max and maximize the force. Take that Vader!