If you’re like most of us, you’d probably like to have a lot more money with a lot less effort. Fortunately, there is an easy way to do this if you want to learn how to make your money work for you. This is called compound interest, which is calculated on your initial principal and also on the accrued interest from previous periods. It is this “interest paid on interest” that causes the snowball, or compounding, effect that rapidly increases your wealth.
To get the most out of compounding, just follow these three simple rules of wealth building.
1. Focus on savings in the first 10 years
When you’re younger, it’s not so much about the type of investments you hold, but more about saving diligently. “Mutual funds or stocks? It just doesn’t matter that much at this point,” says Certified Financial Planner Janet Gray. “Just having a savings account means you’re in the game.”
Indeed, in the beginning, your savings will be the main way to make your money grow. “So don’t focus on being an investment expert from the start,” says investment manager Dan Bortolotti. “Focus on living frugally and adding even small amounts, like an extra $50 or more per month, to your savings. It goes a long way over time, so be patient and focus on the savings. During those early years, just celebrate that you actually have money and are growing your wealth in a disciplined way. “You’re ahead of a lot of people,” Gray says.
2. Be patient
Investment returns matter more towards the end of your savings years. So while compounding is a powerful tool, decent results from compound interest take a very long time to show up, often over 25 years. But be patient. It is during these last years of a savings plan that investment returns take precedence over savings as the primary driver of growth in your portfolio.
“At first, your savings will be a key part of building your wealth, but over the next few years the returns on your investments will play a bigger role in how your money grows,” says Bortolotti. “These capitalization gains can often be huge compared to what your savings are.”
So, over the past few years, you will see big gains by focusing on reducing investment costs and sticking to a good investment strategy. This is when it will pay off the most. Of course, the more profitable your investment, the faster your money will grow, but over the past few years, even a solid 3 or 4% annual rate of return will yield impressive results.
For example, if you have saved for 25 years and have a $1 million portfolio, a 4% return on investment will yield $40,000 per year. If you keep that $40,000 in your $1 million wallet and don’t add a penny more for five years, after 30 years you’ll have $1,216,654, or $216,654, mostly from returns on investment over the past five years. You no longer need to save out of pocket, as the snowball effect will likely take care of your savings goals for you.