The Internet is a funny place sometimes. There’s a claim that has been floating around for years that Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” There’s no evidence that Einstein ever made a foray into commenting on finance, and it’s likely his name was falsely attributed to these words for an appeal to authority. The quote is great though — whoever came up with it should have taken the credit for themselves.
Most people can intuitively picture the shape of a compounding curve, and know that compound interest is when one’s accumulated interest on an investment itself earns further interest. In the context of a graph we probably define someone who has “made it” financially (or is at least very close to doing so) as being when the line representing their portfolio balance starts to go parabolic, compounding on itself at a rapidly accelerating rate.
My net worth (and assets, since I have nearly no debt) is now around $300k and the growth over time still looks very linear. There is a slight upward curve visible during the massive market surge following the March and April 2020 coronavirus crash but that was a period of abnormally high returns, and the stagnation this past year or so means that a linear line is still the best fit for my net worth graph over the roughly seven years that I have been investing. Early on, most portfolio growth will be from one’s own contributions.
The other day I was wondering, how does one know at what point they’ve done enough heavy lifting with their own savings such that compound interest will begin to become the dominant force in their wealth growth? We can see in the simple example chart above that both the compound and simple interest lines are overlapping each other for a time, but then the compound interest line accelerates up and away, gaining that characteristic shape. When will this occur for an individual investor’s portfolio?
I came up with this quick and simple comparison to figure that out:
Annual Savings ⩻ Portfolio Balance * Expected Avg Nominal Return
I like to use an 8% expected annual nominal return for equities. For bonds you can use the yield to maturity, and cash is easy enough with the stated rate on your savings account. Previously I’ve been close to 100% stocks and could just apply that 8% number to my whole portfolio for a quick estimate, but with my down payment fund I’ve got a significant cash drag on my portfolio earning currently only 3%. I calculated a weighted annual return of 6.6% for my current asset allocation.
So on my $300k portfolio, that’s $19,800 in annual interest earned. My annual savings I summed from my most recent two biannual budget reviews:
$58,200 ≮ $19,800
Clearly I’m still nowhere close to that holy grail of compounding, as my annual contributions are nearly 3x larger than the interest I would expect my portfolio to earn in an average year. You can figure out what portfolio balance will be required for the compound interest to surpass your savings by dividing your annual contributions by your expected average nominal return. I came up with $882k for my numbers.You can play around with this popup compound interest calculator from MoneyChimp to see how long it will take you to reach that requisite balance. My result was about 6 years.
The usual obvious caveat with all things personal finance — using averages doesn’t result in a super accurate forecast. Market returns in any given year are highly volatile, so uncertainty rises over shorter timeframes.
For those starting from zero, how would the path to reaching “critical mass” of portfolio compounding look like, dependent on their savings rate and different annual returns?
That’s actually a bit of a trick question! If you increase your savings rate, you are also increasing the corresponding amount of interest that your portfolio needs to throw off before that variable can be greater than your annual contribution value. Saving more will of course increase the final value of your portfolio and allow you to retire earlier, but the relative ratio at which the compounding curve develops will remain the same (assuming equivalent investments).
This is of course also the reason why compound interest is so powerful over long timeframes of several decades. Even for people only saving 10% of their income, that snowball will start rolling after about a decade.
Theoretically if one’s savings rate is high enough, they could achieve financial independence prior to hitting the point where compound interest becomes the dominant force in their wealth growth. For example we see above for an 8% nominal return that this will occur after about 9 years. I’ve calculated in the past that an investor earning a 5% real return (subtracting the historical average of 3% inflation) would need a savings rate of 70% or higher to achieve FIRE in under 9 years. So this metric is completely irrelevant for “super savers.”
The conclusion that I took from this exercise is that there is nothing you can do to accelerate the development of that compounding curve other than earning a higher rate of return on your investments. And besides setting an asset allocation, that is mostly out of our control because the market is going to do what it’s going to do. This is one of the reasons I’ve historically maximized my allocation to stocks for all money which doesn’t have a near-term use. I want that potential maximum growth rate and I’m willing to take the downside risk of working a bit longer.
I think this is why a lot of people fall prey to get-rich-quick schemes like crypto, meme stocks, and trading courses. Investing in stocks the “optimal” way as suggested by game theory involves purchasing diversified index funds and accepting the market average return. This can be a slow slog towards building real wealth.
It can be frustrating watching your net worth grow linearly — or worse, stagnate or decline. What happens month-to-month is truly inconsequential, and there’s no reason to monitor it that closely unless you just enjoy the data collection aspect. I log into Personal Capital exactly once per month to gather the data that I end up presenting on this blog.
If you want to achieve financial independence faster, focus on the things within your control — mostly what you spend, but also increasing your income where possible and choosing the best asset allocation for your goals and risk tolerance.