The Effect of an Additional 5% Per Year in Interest Compounded Over Time Can be Huge
The most commonly cited average historical performance over an extended period of time for the stock market is 7% (this includes both the up and down periods over an extended period of time 30 years or more). This is commonly cited as a benchmark for performance in stock market investing and mutual fund investing. However, there are many mutual funds at this time which cite 5 year and 10 year performance in excess of this, many by 5% or more for the more limited period of time of 5 to 10 years.
My question then becomes: How Much of an Effect on Your Investment Does an Extra 5% Make Over an Extended Period of Time?
To determine the answer to this question, I will use the free future value compound interest calculator at money chimp.com to calculate the future value of an investment of $10,000 over a 30 year period while adding $100 per month, earning an interest rate of both 7% (the historical average) and at 12% (5% per year higher and a number which many mutual funds are presently beating with their 10 year average). The lower future value for the investment earning 7% per year will then be subtracted from the higher interest earning investment to show us how much of a difference 5% makes on this investment for a 30 year period of time. The idea behind this exercise being, does investment selection make a large difference over time.
The first scenario shown includes $10,000 invested over 30 years, adding $100 per month. As you can see the overall investment when compounded one time annually at 7% interest would grow to $85,568.63 at the end of 30 years. This is quite a substantial sum considering the addition of only $100 per month. Imagine if you were to add $250 per month (this would equate to more like $99,000 or so).
Now let’s see what happens when you achieve a higher rate of return (just 5% more per year) over the 30 year period. How much of a difference do you believe it will make? A few thousand, five, ten thousand? Wrong, as you can see from the picture below, rate of return has an exponential impact on overall future value, which compounds and gets larger over time, as your investment grows. Therefore it pays to focus on and pay attention to investment performance and to invest in mutual funds and companies with a solid track record for performance and which charge low fees. This can have a tremendous effect on the overall amount of funds you eventually have to withdrawal in retirement.
In the scenario here, $10,000 was invested for 30 years, adding only $100 per month, but the money earned a higher 12% rate of return on an annual basis. As you can see, the future sum (at the end of 30 years) grows to a substantially higher sum of $323,732.49. This equals an amount which is greater than the above investment by $238,163.36. Over $230,000 difference by earning 5% more on your investment over time. As you can see, investment selection, and saving a few interest percentage points on annual fees each year, can make a significant difference. To illustrate further two more scenarios are shown below. They are meant to illustrate the difference when you start with $20,000 and add $350 per month over a 30 year period earning 7% in one scenario and 12% in the other.
Here you can see that a $20,000 investment with an addition of $350/month earning 7% per year over a 30 year period would grow to $185,306.38. in this scenario you started with twice the amount you started with in the above scenarios (which started with only $10,000) and added $250 more on a monthly basis (more than double what you were adding in the above scenarios). As you can see, this allowed the investment to grow to a sum greater than in the first scenario, but less than the investment of only $10k which grew at a rate of 12% (still ending up with $100k less than the 12% investment, a substantial difference).
Now let’s take a look at what 12% interest on a $20,000 investment, with $350 monthly additions would turn into. As you can see, quite a deal more, ending at $683,664.88. This is all from a $20,000 initial investment with an addition of $350 per month. As you can see, investment performance over time and reducing fee expenses on an annual basis are much larger contributors to future account value than anything else. Therefore, one should wisely research investments and avoid laggards or those which perform in a substandard way for years on end, those which have much higher fees than other investments, to avoid missing out on thousands or even hundreds of thousands in future account value.
Finally, just out of curiosity…..How much of a monthly contribution would it take to have a million dollars at the end of 30 years if I started with an investment of $10,000 and added on a monthly basis earning 12% interest per year? How much of a monthly contribution would it take if I were to start 10 years earlier in time and invest $10,000 at 12% for 40 years? The results are shown below.
In the first scenario, as you can see, it would take $2,900 per month over 30 years earning 12% per year to accumulate $1,000,000 at the end of 30 years. This is an extraordinary sum for anyone to invest on a monthly basis. Now, let’s extend the time period for investing by a 10 year period to 40 years. For example, someone who started investing at 25 aiming for a 65 year old retirement age.
As you can see, the amount invested is still $10,000 but the monthly contribution needed for one to reach $1 million at the end of the 40 years is significantly lower at only $100 per month (a staggering difference), This illustrates the extreme power of starting investing as soon as possible even if you feel you don’t have enough as it can grow tremendously over time and the sooner you start, the better. Additionally, getting your kids started as soon as possible is best. For a 25 year old, if you were able to get $10k together and add $100 on a monthly basis, you could be a millionaire by 65 or sooner. The power of investment returns and time have the most significant impact on your long term wealth and should not be ignored. Get started with automatic mutual fund investing, the sooner the better and see what you can accomplish.