The Beauty Of Compound Interest
Most people are not good with money. Some people are downright terrible with it – but if you are reading this – hopefully that means you are at least slightly interested in taking the first steps to a brighter financial future.
If you are looking for stocks with great Price/Earnings Ratios, the best low cost ETF’s or ways to structure your asset allocation during a recession – this post is NOT for you. If you were confused by that last sentence – THIS IS FOR YOU.
Part 1 – THE POWER OF TIME & COMPOUND INTEREST
The most important thing about investing is getting started. This may seem obvious, but I cannot tell you how many of my friends and family members have continually put it off. The only way to guarantee wealth in the future is to start investing today (or marry a rich girl), but let’s be honest…you aren’t good looking enough DARREN!
What is compounding/How does it work?
Compound interest, simply put is when the interest you make off an investment starts earning interest as well. For example, if you invest $100 dollars and earn 10% interest, you will make $10 dollars. The next year though, you will make $11 dollars (because you now have $110 dollars earning 10%. Over time – the speed at which the money compounds is unbelievable. Take the example below from one of my favourite books “The Wealthy Barber“:**
**If you haven’t read this book yet, and have any interest in bettering your financial situation, or understanding do yourself a favour and READ IT!
“Teen 1 saves $2,000 each year from ages 19 to 26 and invests it in an account that earns a return of 10% per year. She then no longer contributes anything, but leaves that money in the account until age 65. The total value of her investment at that time would be $1,035,160.
Teen 2 does not start saving until age 27. He saves $2,000 each year from ages 27 to 65 and invests it in an account that also earns a return of 10% per year. The total value of his investment at age 65 would be $883,185.
Teen 1 will have contributed a total of $16,000 and at age 65 increased the value of her deposits by 64 times.
Teen 2 will have contributed significantly more at $78,000 (39 years x $2,000.00), but will have increased the value of his deposits only by 11 times.”
Another great example of the wonders of compound interest. Answer the question below:
Would you rather have 1 million dollars right now, or a magical penny that doubles in value every day for 30 days?
90% of people say they want the $1 million dollars. That means 9 out of 10 people JUST don’t get it. That magical penny would be worth over FIVE MILLION dollars after 30 days. Don’t believe me? Look at the chart below:
The power of compound interest, can turn anyone with patience and a small amount of disposable income into a millionaire!
By this point, you must be ready to start investing – how could you not be. However, investing can be scary – I get it. Here are a few questions I hear quite frequently:
- What should I invest in?
- What If I lose all my money
- The stock market is at an all time high – shouldn’t I wait? Buy low sell high right?
What should I invest in:
First of all, there is no single correct answer to this question. If anyone tells you there is – RUN. The most important thing is to get started. Automate payments every time you get paid, and choose something that fits your risk tolerance. For beginners, I’d recommend a low cost ETF, which is basically the exact same thing your bank will try to sell you – but with lower fees. That said, if you take comfort in the guy/girl at the bank, and you trust the bank – by all means invest in the mutual fund they recommend – it is still 100% better than NOT investing. I started investing in mutual funds when I was 18 years old, and only recently sold some of them/transferred them to low cost ETF’s.
What is a Mutual Fund/ETF
A Mutual fund is a group of stocks/bonds that are packaged together and managed by a professional. They charge you a % each year(usually 1-2%) to mange the account for you. The benefit of an fund is you get instant diversification on hundreds of stocks and bonds without needing the cash to buy each one. You own shares/units in the fund, which in part own all the underlying assets of the fund. There are many different types of mutual funds, some will be focused on equity (stocks), others on fixed income (bonds), some will be balanced (both). There will be some mutual funds that are Canadian focused, others that are US or Global focused. Some funds will be focused on paying you each month – others will be focused on long term growth. There really is a fund for everyone. The goal of the mutual fund’s manager will be to try and “beat the market”.
Study after study has shown that the majority of mutual funds actually underperform the market (due to trading fees, commissions, and in some cases poor fund managers). An ETF (Exchange Traded Fund) is very similar to a mutual fund, however the goal is to simply replicate the market. Just like a mutual Fund, ETF’s come in all shapes and sizes, but because their goal is to replicate the market, there isn’t much managing of the fund going on – and this usually results in much lower fees for YOU the investor.
Disclosure: I currently own both Mutual Funds and ETF’s. You can view them on my portfolio tab.
Choosing the right fund, will come down to your own goals, risk tolerance, time horizon and more. Do your own due diligence, but remember, choosing a poor performing fund that only returns 4% per year, is still better that not investing! Feel free to ask any questions in the comments, or send me an email if you have any specific questions.
Investing is Scary…What if I lose all my money:
This is the beauty of owning an ETF or a Mutual Fund. It is virtually impossible for you to “lose all your money”. Most funds will consist of over 100 different stocks (sometimes thousands). For you to lose all your money, every single stock you own would have to go belly up. Sure, sometimes your funds will go down, sometimes they will go up, but just remember the average return over the last 100 years is around 7%. As a general rule, you want to be more aggressive when you are younger (higher risk, higher returns), and reduce your risk as you get closer to retirement (switch from a lot of stocks, to a balance of stocks and bonds, or if you’ve built up a big enough portfolio perhaps mostly bonds).
It would be possible to lose everything if you were to own one individual stock, however until you are an experienced investor, and can stomach volatility and major losses – I wouldn’t recommend owning individual stocks. (And Even if/when you do venture into owning individual stocks, you should still diversify)!
The stock market is at an all time high – shouldn’t I wait? Buy low sell high right?
Once again, study after study has shown that:
TIME IN THE MARKET > TIMING THE MARKET
What this means is that, over any long period of time you will be better off investing for NOW, than you would be trying to time the market/buy when stocks fall. Even if the results were different, it wouldn’t matter, because NOBODY can time the market perfectly. If someone tells you they can – RUN. Need another reason to start today (instead of waiting for a market dip) – go back an re-read the compounding section.
Part 2 Investing Accounts:
In Canada, there are different types of accounts in which you can hold your investments. I am going to touch on the two most popular, and explain them in simple terms.
Option 1 – RRSP: Registered Retirement Savings Plan
The RRSP has been the most popular retirement/investing plan around for years (and for good reason). An RRSP, is an account in which you can hold *most* investments(stocks, bonds, cash, etc). The RRSP is registered with the government of Canada, and any contributions you make throughout the year can be used as tax deductions when you file your taxes (reducing the amount of taxes you need to pay – which usually results in getting some extra $$$ back at tax time). All money invested, and all the gains will grow tax free inside your RRSP, until you are ready to start withdrawing funds (usually, in retirement, and when in a lower tax bracket).
There are limits on how much you can contribute to an RRSP each year, and there are penalties for withdrawing from your RRSP early, so make sure to read all the rules before getting started. That said, in most cases, anyone earning $60,000 or more per year, should be investing via an RRSP (because you will be in a higher tax bracket, and benefit from a large reduction in taxes owing). If you earn under 50k per year, you may be better off investing via OPTION 2:
Option 2 – TFSA: TAX FREE SAVINGS ACCOUNT
Most people I talk to, even those who have a TFSA, seem to think this is just another every day savings account, when in truth, this is one of the most powerful investment vehicles around. The Tax Free Savings Account (should have been called the Tax Free Investment Account), can hold *almost* any investment, much like an RRSP, however there are some restrictions. For more information you can check the Government of Canada’s website: HERE
How does a TFSA Work:
The main difference between a TFSA & RRSP is that there are no tax benefits/deductions to invest in a TFSA, and you cannot claim any investment losses, however any money you contribute to your TFSA, along with any investment income earned, capital gains, dividends, etc can be withdrawn TAX FREE at any time. For example, if you invest $10,000 into your TFSA, and in 10 years, that investment is worth $50,000 you can withdraw the full amount, without paying a penny in taxes.
Like an RRSP, there are contribution limits to a TFSA, and penalties if you go over them. You can however withdraw money at any time without penalty, which makes a TFSA a lot more flexible for people saving up for shorter term things (house down payment, tuition, etc).
Generally speaking, in most cases, higher earners will benefit more from an RRSP, and lower income earners will benefit more from a TFSA (some will use both). In 100% of cases, investing via either account is better than NOT investing. Are you sensing a trend yet?
What are you waiting for? Get started today!
This post was meant to give the uninitiated, a VERY BASIC look at how & why they should get started investing. If I have convinced you – I urge you to go to your financial institution, get set up with a TFSA, or RRSP (or both), and start making automatic contributions every payday. It doesn’t matter if you can only afford a small amount (I started when I was 18, investing $25 a month). You’ll barely notice the amount coming off each pay cheque, and eventually you can increase how much you put away. Although the first few months/even first few years may seem slow, you will soon start to see the magic of compound interest working in your account, and if you invest via an RRSP, you will most likely be pleasantly surprised at tax time when you get a much bigger return.
I said it earlier, but I think it’s worth repeating:
The power of compound interest, can turn anyone with patience and a small amount of disposable income into a millionaire!
Best of luck!
To my *very few* regular readers – I know this post is obvious to you, but If I can even help 1 person, I don’t care if I wasted your time 😉
Please note,I am not a licensed financial advisor, all views are my own, and always do your own due diligence.
Moneymaaster 