Why Index Funds Win
The Compounding Engine
The Compounding Engine
Albert Einstein may or may not have called compound interest the eighth wonder of the world. He was right either way.
Compounding is the process by which your returns generate their own returns. It is exponential, not linear. And it makes time the most powerful variable in investing.
The Rule of 72
To quickly estimate how long it takes your money to double at a given return, divide 72 by the annual return rate.
| Annual Return | Years to Double |
|---|---|
| 4% | 18 years |
| 6% | 12 years |
| 8% | 9 years |
| 10% | 7.2 years |
The US total stock market has returned roughly 10% annually before inflation since 1926. At that rate, your money doubles approximately every 7 years.
Why Starting Early Crushes Everything Else
Meet Alex and Sam.
Alex invests $5,000/year from age 22 to 32 (10 years), then stops. Total invested: $50,000.
Sam invests $5,000/year from age 32 to 62 (30 years). Total invested: $150,000.
At age 62, assuming 8% annual returns:
- Alex: $602,000
- Sam: $566,000
Alex invested one-third the money and ended up with more. Those 10 early years of compounding outweighed Sam's 30 years of contributions.
Time in the Market Beats Timing the Market
The temptation is always to wait -- for a correction, for clarity, for the right moment. That temptation is expensive.
A study by Charles Schwab looked at five strategies applied to a $2,000/year investment over 20 years:
- Perfect market timing (invested at the bottom every year)
- Invest immediately on January 1st each year
- Dollar-cost average (invest a fixed amount monthly)
- Invest at the peak each year
- Never invest (keep it in cash)
Results after 20 years:
- Perfect timer: $151,391
- Immediate investor: $135,471
- Dollar-cost averager: $134,856
- Worst timer: $121,171
- Cash: $44,438
The difference between perfect timing and just investing immediately was $15,000 over 20 years. The difference between investing immediately and sitting in cash was $91,000.
Being in the market matters infinitely more than when you enter it.
The biggest compounding killer is not a bad market -- it is waiting. Every month you delay investing is a month of compounding you cannot get back. There is no catching up. You can invest more later, but you cannot recapture lost time.
Using the Rule of 72, how long does it take to double your money at a 9% annual return?