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How to Make a Million Dollars, The Simple Way
It's not clickbait, it's compounding.
Hello everyone, Happy October & welcome back to Vitality Digest. Today marks the launch of our first deep dive issue. Our social polls indicated that most people are interested in dissecting a finance topic. So today we’ll be exploring the concept of compounding and how it can potentially turn you into a millionaire (or add a few more millions, if you already are one).
Before we begin, let’s clarify a few important things right from the outset.
I am not a finance or productivity guru. Nor do I ever intend to be. This piece here is not financial advice. It’s an idea or a suggestion that has proven to positively impact millions of people and may do that for you too. In the end, it’s your choice to take into account, all the facts and make a decision.
My job here is curation. Vitality Digest is designed to bring you evidence-based industry ideas on a plethora of topics that enable you to live eudaimonic lives. We’ll save you the trouble of constantly searching for elements to incorporate for holistic living and bring those ideas to your email every week. By the way, Thank you for subscribing! I appreciate you. Spread the word if you can.
The idea of using compound investing to accumulate millions of dollars is not a novel concept and has been a topic of discussion in numerous articles and books. Compounding may not be the quickest or the most optimal method to earn a million dollars (there is indeed a superior approach for amassing millions, but that's a discussion for another time), yet it stands as one of the most straightforward approaches available.
Aight, let’s dive in.
At its core, compounding is the process of earning interest or returns on an initial investment, and then reinvesting those earnings to generate additional income. It's often described as "earning interest on interest." The underlying concept that makes compounding so powerful is the exponential growth curve of compound interest.
Compared to the simple interest which follows a linear growth curve (as it is calculated based on the initial amount invested), compound interest multiplies money at an accelerated rate. Because with compounding, in addition to calculating interest on the initial principal amount, the accumulated interest from previous periods is also factored in. This results in an exponential growth curve.
The impact of time creates a major difference between simple and compound interest. With simple interest, the interest remains constant regardless of how long you’ve invested the sum.
With compound interest, an increase in compounding periods directly increases the returns you get at the end of the day. The longer your money is invested in a particular investment, the greater the returns will be.
Understanding the Mechanism
The formula for compound interest is: A = P(1 + r/n)^(nt) Where: A = The future value of the investment/loan, including interest. P = The initial principal amount. r = The annual interest rate (in decimal form). n = The number of times that interest is compounded per year. t = The number of years the money is invested or borrowed.
Although simple, unless there is an apocalypse where all electronic systems are shut down, you’ll probably never need to calculate compound interest on a piece of paper. Plus if there is an apocalypse, we’ll have bigger problems to deal with, such as panic-buying toilet paper like lunatics. I digress.
So here’s a compound interest calculator that’ll do the work for you.
Now let’s take an example to put the compounding effect into perspective.
Imagine you're saving for a dream vacation, and you decide to put $100 into a special savings account. This account offers an annual interest rate of 10%.
Scenario 1 - Simple Interest
Year 1: With simple interest, you'd earn $10 (10% of $100) in interest for the first year. Your total savings after one year would be $110 (your initial $100 + $10 interest).
Year 2: In the second year, you'd still earn $10 in interest because simple interest doesn't change. So, after two years, you'd have $120.
Scenario 2 - Compound Interest
You start with your initial savings of $100.
At the end of the first year, your savings grow with compound interest: A = $100 × (1 + 0.10)^1 A = $100 × 1.10 A = $110
In the second year, your savings continue to grow with compound interest: A = $110 × (1 + 0.10)^1 A = $110 × 1.10 A = $121
After two years, you have $121 in your savings account.
The additional $1 might seem modest, but it demonstrates the compounding effect. Over time, the difference becomes more pronounced, allowing your money to grow significantly faster than with simple interest.
Playing the long game
We emphasize that investing with compound interest entails playing the long game, and it's not necessarily the quickest route to a million dollars. This doesn't imply that it's a negative approach. But in all honesty, many of us would rather see our wealth reach a million dollars by the age of 30 or 40 rather than wait until we're in our 60s or 70s.
Compound interest is a tried-and-true method for accumulating wealth. It allows you to grow your initial savings into a substantial sum over the years, helping you reach your financial goals and secure your future. The key is to be intentional about it and start early.
At this point, it’s important to talk about the book that delves into compounding and the necessity of starting early in much greater detail. The Psychology of Money by Morgan Housel is one of the most impactful financial well-being books out there and we highly recommend everyone reading it at least once. Read it again after a while to make the most out of it.
Now let’s take the same example described above and see how it plays out long term.
Suppose you start investing $100 per month in a savings account that yields 10% interest.
In year 1, you’d have contributed $1300 (initial investment of $100 + 12 contributions)
By year 10, you’d have contributed $12,100 and have a future value of $20755.20
Now the fun part begins.
By year 20, you’d have made $76,669.69. Nice. Your total contributions at this point are $24,100
The process repeats and by year 30 you’ve made 228,032.53 with total contributions of only $36,100
Year 40 will yield 637,778.02, Year 50 will put you up at a $1.75 million valuation with only $60,100 in contributions.
Year 60 will more than double your valuation at 4.75 million and at year 70 you’d have entered the deca millionaire club ($12,877,906.17) with only $84100 in contributions. Of course, at that point, you’d be too old to make any use of it. But whosoever inherits it will be living the dream.
Remember you’re still only investing 100$ per month. Of course, the time value of money and inflation come into play but this is just a simple example of what compounding can do for you.
Warren Buffett, chairperson of Berkshire Hathaway had a net worth of around $67 million at age 47. About a month ago, Warren celebrated his 93rd birthday and is worth around $120 billion (with a b). This is not only because he is a great investor, but also because he is an early investor. (He started investing at age 10).
What are the odds you’d become a millionaire?
Better than that $5 lotto max + extra
Seriously, your shot of winning the jackpot is 1 in 33.294 million. But you know what they say, today’s the day mate.
But let’s get real. The likelihood of making a million dollars from investing depends on a lot of factors.
Initial investment: The more you can initially invest, the faster your money can compound towards a million dollars.
Annual Contributions: Regularly contributing to your investments can significantly impact the speed of wealth accumulation.
Interest Rate: A higher interest rate will lead to faster growth, but it's often accompanied by higher risk.
Time Horizon: The longer you invest, the more time your money has to compound, increasing the likelihood of reaching a million dollars.
Risk Tolerance: More aggressive investments might offer higher returns but come with greater risk.
Market Conditions: Economic conditions and market fluctuations can influence the speed of wealth accumulation.
Why everyone should invest
While it might seem daunting or reserved for the financially savvy, the reality is that investing is a path open to everyone, and there are compelling reasons why everyone should consider it
Firstly and most obviously, Investing provides a means to grow your wealth over time. Whether it's creating an emergency fund, saving for retirement, or achieving other financial goals.
Next, it helps us beat inflation. Over time, the purchasing power of money decreases due to inflation. Investing offers the potential for returns that outpace inflation, ensuring your money retains its value and continues to grow. The average inflation rate in Canada in the year 2022 was 6.8%. Yeah, that annual 5% salary bump is not looking great after all, is it?
Successful investing can also lead to financial freedom. It means having the resources to live life on your terms, whether that involves early retirement, pursuing passions, or taking calculated risks. plus, it also offers the opportunity for personal growth and learning. Understanding financial markets, making informed decisions, and adapting to economic changes can be intellectually stimulating and empowering.
Where to get started?
This brings us to our esteemed sponsor of this post, Wealthsimple Trade. (Just kidding ;) Although, Wealthsimple team - if you’re reading this, don’t hesitate to get in touch!)
There are a few prerequisites that you may want to take into consideration before you begin to invest. Again, this is not financial advice. You know your financial condition better than us.
Pay off high-interest debt: Prioritize paying off high-interest debt, such as credit card balances, before heavily investing. High-interest debt can erode potential investment gains.
Create an Emergency Fund: remember we’re playing the long game here. The funds invested shouldn't be taken out to truly realize the benefits of compound interest. Ensure you have an emergency fund with three to six months' worth of living expenses saved in a liquid, easily accessible account. This provides a safety net for unexpected expenses.
Assess Your Risk Tolerance: Understand your comfort level with investment risk. Your risk tolerance will influence the types of investments you choose.
Set a Realistic Budget: Evaluate your current income, expenses, and savings rate. Establish a budget that allows you to allocate funds for investing without jeopardizing your daily financial needs.
There are a few ways to get started with investing, the stock market being the most prevalent one.
Stock Market - Index Funds
We generally suggest investing in Index funds such as the S&P 500 but it’s important to clarify that compounding in this context is different compared to traditional investments such as a savings account.
In the case of the S&P 500, a stock market index that tracks the performance of 500 of the largest publicly traded companies in the United States, the stock itself doesn't compound, but the individual components within the index generate returns in the form of price appreciation and dividends. When investors reinvest their gains and dividends, they experience compounding growth in their portfolios over time.
Investing in an index fund diversifies your portfolio which helps spread risk across multiple assets, ensuring you remain net positive if something unusual happens.
Index funds are also known for their low expense ratios. Because they aim to replicate an existing index rather than actively manage investments, they have lower management fees compared to actively managed funds. This cost efficiency can lead to higher returns over time. You can play with the mix of portfolio allocation. 80-90% of investment in low-cost index funds with 10-20% allocation to experiment with stocks can be one strategy.
Fixed income securities- Bonds
Fixed-income investments are debt securities that provide regular interest payments and return the principal amount at maturity. They are considered lower-risk compared to equities (stocks) and are often sought after for their income-generating potential
Bonds pay periodic interest (coupon) and return the principal at maturity. Reinvesting coupon payments can lead to compound interest.
Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Many mutual funds offer the option to reinvest dividends and capital gains again making use of the compounding effect.
While the interest rates in traditional savings accounts are relatively low, they still offer compound interest. Consider high-yield savings accounts or certificates of deposit (CDs) for potentially higher returns.
Finally, most countries offer some type of investment account that is tax-efficient. In Canada, we’ve got a TFSA (Tax-free savings account). The primary advantage of a TFSA is that any investment income earned within the account, such as interest, dividends, and capital gains, is tax-free. This means you don't pay taxes on these earnings, even when you withdraw them.
The government sets an annual contribution limit for TFSAs. The contribution room accumulates each year, even if you don't make a contribution. You can carry forward unused contribution rooms indefinitely.
You can learn more about it here.
That’s it for this week’s issue. I hope you’ve enjoyed our first deep dive and found some value from it. Finally, it would mean the world to me if you shared it with your friends and family. Sharing is the most powerful and important way for others to discover Vitality Digest and join our vibrant community.
Stay vital and have a great week.