The Magic Principle of Compound Interest

Getting a return on your money is the basic principle of capitalism. Even if you are the lowest man on the economic totem pole, you still have a cash flow. Always pay yourself first. But do not just stuff money under a mattress, put your money in an investment.

An investment is a place to store your money, for the advantage of a return, or gain. All things being equal, the higher the return, the greater the risk. For example owning stocks over time has a net return of better than ten per cent. That is the return, or what you get, looking at the Dow Jones Average (a broad measure of equities, or stocks) over almost any ten year time frame in the history of modern America. Bonds, or loaned money, typically will return five per cent. Stocks are considered to be riskier than bonds, because if a company goes bankrupt, the bondholders get paid before the stockholders split up the rest of the remaining assests.

Now comes the fun part, the Rule of 72 is a quick mental computation even a child can perform that tells you how long it will take your money to double at any given interest rate. Simply divide your interest into the number 72, and the remainder will be the number of years that it takes your original principle amount to double. For example, six into seventy two equals twelve. So if you invest $1,000 dollars at a six percent return, in twelve years, your total investment has grown to $2,000. Now quickly flip those numbers, divide a 12% interest rate into our magic number of 72, and you will see that in merely six years, your original investment, in this case, $1,000 has grown to $2,000.

Let us take a look at the practical implications of investing in stocks, verses bonds over a 36 year period. Let us assume that each year you put $1,000 in a IRA based upon the Dow Jones Average, and you put $1,000 in a bond fund, in this case a US savings bond yielding a 4% annualized return.

Now where do you want to be at retirement? For extra credit, perform this simple exercise with your Social Security tax. The rate of return for your Social Security trust fund is less than two per cent. A person earning just minimum wage earns about $15,000 per year, and therefore contributes $1,125 in this payroll tax each year. Just to add a little more reality, you are probably asking yourself, sure, who makes 12% on their investments? Take a look in your wallet, what is the rate of interest that your credit card company is charging you?