Bridging The Gaap

Part 1- Simple vs. Compound Interest - Part 2 - How Can I Make My Money Grow? - Part 3 - Time Is Money!

How Do I Start My Money Compounding?

Now, when I say compound interest is free money, well, I’m sort of bending the definition a bit. You have to do things in order to get this free money (no such thing as a free lunch, remember!)

The easiest, and safest, way to start growing your money via the power of compound interest is to simply…leave it in the bank! When you leave money in the bank, it’s like you’re money to the bank. Just as you would have to pay a loan you took from the bank back with interest, so too must they offer you something for keeping your money in THEIR bank, and not the one down the street (or not at all). We’ll go over this more in a future article, all about how banks work (coming soon!).

The trouble is, banks don’t offer much interest. In most cases the interest earned on your savings in a bank account will not outpace inflation. If you’re lucky, a high interest savings account will offer 3.5%, but that can change from month to month depending on the economic climate.

Many people then, seek to take advantage of the power of compound interest by investing. There are different ways to invest, but to keep it simple, let’s assume you’ve decided to invest your money in a low cost index fund.

Low cost index funds are mutual funds that are specifically tied to a market index like the S&P500, the S&P/TSX60 or the Wilshire 5000. These are used as broad indicators of how the whole stock market is doing at any given time: this is what you will see reported on every night on the news. The index fund tracking a particular index will only buy the stocks that are in that market index, in exactly the same proportion: the goal is to try to follow the WHOLE market, instead of trying to pick and choose stocks within it. This is, according to some very prominent thinkers and investors like Burton Malkiel, John Bogel and yes, even Warren Buffet, probably the best investment vehicle for the average person (though always talk to your fee only financial planner first!).

The stocks that make up the S&P500 have historically returned about 10.4% per year (this becomes a real return of about 7.2% when you factor in the average inflation rate in that same time period (source)

So investors take money they would otherwise spend, or put in the bank, and invest it in this index fund. They do this because they are expecting a higher return from investing (10.4%) than they would get from the bank (3.5%) or from spending it (0%, assuming it’s not spent on things that will make them money).

Now remember when I said compound interest can make you HUGE sums of money? This is due, in part to the rate of return you get. You’ll make more money if your money is compounding at an average rate of 10% than you would if you were earning an average rate of 3%!

An equally important factor in how much your money is able to compound is TIME itself. Simply put, the longer you have the more you’ll make!

Let’s find out why in part 3!

Part 1- Simple vs. Compound Interest - Part 2 - How Can I Make My Money Grow? - Part 3 - Time Is Money!

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