The secret to growing your wealth is compounding. Here’s how it works
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Albert Einstein is often credited with coining this famous saying, despite a lack of clear evidence that he ever said it. No matter: The quote cuts to the heart of investing — why it works and why we do it — regardless of who came up with it. The sheer power of compound interest creates futures and financial freedom. It is also central to Jim Cramer’s decades-long mission to help investors select stocks for the long term, as outlined in his new book, “How to Make Money in Any Market.” The reason? Small but consistent gains made over time through compounding can supercharge your wealth. It’s all about time spent in the market, not market timing, according to another well-known Wall Street adage. Larry Fink, co-founder and CEO of BlackRock , the world’s largest money manager, championed the strength of compound interest in a recent interview with Jim on “Squawk on the Street”: “If you put money to work on January 1, 2000, and a year later, you had the dot-com crisis, six or seven years later, you had the financial crisis, [and then] you had the Covid crisis. You still would have made 8% compounded over that entire 25-year period,” Fink said, later adding: “It’s about being in the market throughout the cycle. I’m not here to tell anybody if the markets are going to go up or down. But over the long horizon, every individual who’s thinking about it should be focusing on these opportunities.” How is that possible? The S & P 500 closed on Jan. 3, 2000, a Monday and the first trading day of that year, at 1,455. The index closed on Friday, Oct. 24 at 6,791. That’s a 366% return over nearly 26 years or just over 6% per year. Do the same math with the Nasdaq ‘s 471% total return over the same time period, and it comes to about 7% per year. That’s just the price return; add in the dividends you receive when owning an S & P 500 index fund, and you get to right around that 8% Fink was talking about. Compare that to cash in a savings account earning less than 1% nowadays — or even the best money market accounts yielding 4%, roughly the same as the 10-year Treasury . Those returns are much lower than what the stock market has historically delivered. We should also briefly touch on real versus nominal returns. Nominal returns refer to the absolute rate of return, without any consideration given to buying power. In investing, however, buying power is what matters at the end of the day. The change in buying power is determined by your real return, which is what you get when you take your nominal return and subtract the rate of inflation, which eats away at buying power. For example, if you’re sitting in cash, generating zero percent nominal returns in a world in which inflation is running at 2%, then your real return is actually negative 2% annually. Put another way, your buying power declines by 2% every year from the prior year’s level. So, if you start with $100, then the buying power is worth more like $98 by the end of year one. Another 2% loss on that, and by the end of year two, that $100 you started with is more like $96.04. By the end of year three, your buying power is closer to $94.12. Fast forward, and after 10 years of sitting in cash, while inflation eats away at your buying power, that $100 you worked so hard for and saved so diligently is only going to buy you what $81.71 can buy you, in present terms. If you generate a nominal return equal to the rate of inflation, your real return is zero percent; you won’t be increasing your buying power, but at least you will be maintaining it. So, to increase your buying power over time, you at the very least need to be generating a nominal return above the rate of inflation. Understanding this should make it clear why we all need to be investing. By not doing so, we constantly and consistently lose buying power thanks to inflation. Long-term investing is the key to securing your nest egg. It’s far easier to achieve “smaller” gains every year in high-quality stocks than hit the lottery just once in a wildly speculative name. By smaller, we don’t mean slightly above the rate of inflation. After all, the S & P 500 , the standard benchmark for passive equity investing, returned about 10% annually since 1957. You can double your money every seven to eight years. Going back to Fink’s point, $100 invested for 30 years at even just 8% amounts to a total ending value of $1,006.27, whereas an 8.5% return turned into $1,155.83. In other words, that extra 0.5% return every year adds up to an additional 150 percentage points of cumulative returns over a 30-year period. The key to all of this is time. Compounding starts slowly before it really ramps up as the percentage gains are realized on increasingly large numbers. Thus, the term compounding, the most recent gain compounds on top of all the gains that came before it. That’s why it’s so important to start young. The earlier you start, the more time you have to realize the power of compounding. That’s especially true when it comes to retirement planning. The earlier you start, the quicker the numbers climb and the faster you get to your goal. To better illustrate the importance of starting early, let’s consider three scenarios — all to retire at 65 years old. If we assume you invest $20,000 at age 35 and compound what you have at the market’s historical return over the past 68 years of 10% per year, by the time you reach 65, you would have $348,988. At 25, investing $10,000 — half of the previous example — turns into $452,592 over a 40-year time horizon. To achieve the same result of $10,000 compounded over 40 years, a 45-year-old with only a two-decade compounding horizon would have to initially invest just over $67,000. Keep in mind, these scenarios assume no additional contributions beyond the starting principle. Throw in a monthly contribution, and you really start to see just how incredible the power of compound interest can be — that’s because you are now not only compounding the initial principle, but each monthly contribution as well. Bottom line Understanding and harnessing the power of compound interest is the key to financial freedom. This is not financial wizardry, nor does it require best-in-class Warren Buffett-sized returns. It simply requires a disciplined savings plan, consistent investing, and trust in the process. With those things ingrained in our minds, we can all build wealth no matter where we start from. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
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