Compound interest might not exactly be the financial miracle that some people claim it is, but it's still a powerful force and an essential concept for retirement planning. You can use it to your advantage to fuel wealth creation, but it can also be harmful for people who aren't careful. Make sure that you understand the ways that compound returns function, so that you can unlock the advantages and avoid associated pitfalls.
Einstein's observation
The quote, "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it," is often attributed to Albert Einstein. He was a pretty smart guy, so it's fair to assume that there's some wisdom in that assertion. Regardless of the specific context of that quote, Einstein astutely cited the consequential power of compound interest in finance, investing, and economics.
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Compounding is a repetitive process that can magnify gains -- or expenses -- over the long term. It's a fairly simple mathematical concept, but the full consequences of compounding aren't always apparent. Failure to respect those consequences can be catastrophic for a financial plan.
Exponential growth
Compounding creates exponential growth. Interest-bearing financial products, such as savings accounts, CDs, or bonds, produce income based on a percentage of the capital invested in those products. Consider a $100,000 account that pays 5% interest each year. After the first year, there will be $105,000 in that account, and the 5% in the next year gets paid on a larger number. As the asset grows, so too does the amount of returns generated each year.
The chart below illustrates the growth over a 30-year period for an account with simple 5% annual interest. Note the exponential nature of the curve. The annual return grows from $5,000 in year one to nearly $20,000 by the final year.
Chart by author.
If you are the someone "who earns it" from Einstein's quote, then you are utilizing a powerful force to build assets. Generating income on interest that you've previously earned can totally transform a retirement plan for the better.
Compounding growth in equities
Compound interest doesn't technically apply to stocks, because common stocks don't pay interest to shareholders. However, the same compounding principle applies to equities.
Stock prices tend to reflect the future cash flows that are expected to be produced by the underlying businesses. Equity valuations rise and fall in the short term thanks to supply and demand in capital markets, but long-term performance almost always reverts to cash flows eventually. At some point in a successful corporate lifetime, cash is distributed to shareholders, either as dividends or in a lump sum when the company is acquired by another. When push comes to shove, these events produce returns for shareholders, and a stock's price generally can't stray too far from those expected future returns over the long term.
Historically, growth rates for corporate profits and dividends have moderately outpaced the growth rate of the economy in general. Mature stocks that pay dividends distribute a proportion of free cash flow, and those distributions tend to rise as the company builds profits year after year. Businesses that don't pay dividends still deliver compounding returns by expanding operations, which leads investors to expect larger cash flows in the future, which leads them to drive the stock price up.
S&P 500 Earnings Per Share data by YCharts
If you reinvest dividends and continue to hold stocks as their underlying businesses grow, your returns should reflect a powerful compounding effect.
Compounding expense
Don't overlook Einstein's more ominous reference to people who pay compound interest. Unhealthy debt can wreak havoc on a financial plan. Deferring interest payments on loans or credit cards means that interest accrues and adds to the outstanding balance. This increases the total interest paid.
Incurring compound interest can have dire effects on a financial plan. Higher interest payments obviously increase expenses, but the opportunity cost might be even more important. Every dollar that goes out the door as interest can't be invested. If you pay compound interest, you have even fewer resources to benefit from compound interest. The power of compounding cuts both ways. Make sure that you use credit responsibly.
The importance of starting early
The exponential curve underlines the importance of starting to save for retirement early. The more periods that you have for compounding, the larger its effect. You can't get to the huge returns of the 30th year of compounding without building through the first 29 years of growth.
Every year that you delay saving for retirement removes one lucrative year from the back end of the curve. Start saving as early as possible, even if it's modest at first -- it can make a huge difference a few decades down the road.
