If you’re like most of us, you probably wish you could have a lot more money with a lot less effort. Luckily, there’s a simple way to accomplish this if you’re willing to learn how to put your money to work for you. It’s called compound interest, which is calculated on your initial principal and also on the accumulated interest of previous periods. It’s this “interest paid on interest” that causes the snowball affect—or compounding—that rapidly grows your wealth.
To take maximum advantage of compounding, just follow these three easy, wealth-building rules.
1. Focus on savings in the first 10 years
When you’re younger, it’s not so much about the type of investments you hold but more about just diligently saving. “Mutual funds or stocks? It just doesn’t matter much at this stage,” says certified financial planner Janet Gray. “Simply having a savings account means you’re in the game.”
That’s because at the beginning, your savings will be the key way of growing your money. “So don’t focus on being an investment expert early on,” says investment manager Dan Bortolotti. “Focus on frugal living and adding even small amounts, like an extra $50 or more a month, to your savings. That goes a long way over time so be patient and focus on savings.” In these early years, just celebrate the fact that you actually have money and are growing your wealth in a disciplined way. “You’re ahead of a lot of people,” says Gray.
2. Be patient
Investment returns matter more towards the end of your saving years. So while compounding is a powerful tool, decent outcomes from compound interest need a very long time to appear—often more than 25 years. But be patient. It’s in these later years of a savings plan that investment returns overtake savings as the main engine for growing your portfolio.
“At the beginning, your savings will be a key part of building your wealth, but in later years, your investment returns will play a bigger part in growing your money,” says Bortolotti. “These gains from compounding can often be enormous in comparison to what your savings are.”
So in these later years you’ll see big gains from focusing on lowering investment costs and sticking with a good investment strategy. That’s when it will pay off most. Of course, the better your investment returns, the faster your money will grow but in these later years, even a solid 3% or 4% annual rate of return will yield impressive results.
For example, if you’ve saved for 25 years and have a $1 million portfolio, a 4% investment return will yield $40,000 annually. If you keep this $40,000 in your $1 million portfolio and don’t add another penny for five more years, after 30 years you’ll have $1,216,654—a full $216,654, mostly from investment returns in these last five years. You don’t have to save any more of your own money out of pocket because the snowball effect will likely take care of your savings goals for you.
3. Don’t forget to invest in yourself
Of course, saving money is great and so is investing well for the long haul, but don’t miss out on the great monetary returns you can get by simply investing in yourself. Take professional courses and develop skills that will qualify you for jobs and careers that are financially and personally rewarding and that can up your salary significantly as you get older.
“It’s never too early to save for retirement—that’s true,” says Bortolotti. “But there’s nothing wrong with investing in other priorities that may pay off in the long term in a way investing in a stock portfolio won’t. Oftentimes, building a career you love can offer the best dividends—both personally and financially.”
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