The Magic of Compounding

Scene: Following Dylan’s demonstration that Mutual Funds underperform Index Funds, Amber wonders how big a deal that really is. Will making a little less each year due to fees really have that big of an impact? Dylan does the calculations to show just how powerful Compounding can be.


“Let’s say you invest $100 each in a mutual fund and an index fund and they both went up at 8% a year, but the mutual fund charged 3% in fees, reducing your gains to only 5% a year. Guess how many years it’ll take for your $100 to reach $10,000?”

“I don’t know. How many?”

“No idea.”

“Swift, Dylan.” I took a ladyfinger and bit off the end.

“I thought you needed those for dessert?”

I threw him my mother’s don’t mess with me look.

He fled back to the laptop. “That’s the great thing about the internet. You don’t need to know something to have the answer within minutes. Give me a second.”

I lay another layer of pasta into the dish while Mr. Librarian pecked at my laptop. I had to admit his geekiness about all this stuff was pretty cute.

Dylan entered his data into an investment calculator. “OK, the index fund would take 60 years to grow to $10,000. At the same time, the mutual fund would only be worth $1867.”

“Less than a fifth as much?” I whistled. How could 3% add up to be so much?

“That’s the magic of compounding.”

“Is that what you aim to get? Around 8% a year?”

“No, that’s what the stock market as a whole tends to return over time. Index funds can be great for those who want to park their money somewhere and not have to think about it. My Cash Machine is something different entirely. I aim to double my money every five years, which means I need to get at least 15% annual growth.”

“And you’ve been able to get that?”

“I’ve averaged over 20%, partially because real estate in our market has continued to go up.”

Any hopes I had of winning the bet had long since dissipated. Now that my competitive side had been reined in, I could start appreciating Dylan for what he’d done. Beneath the grimy fingers and tattered shirt was a guy who had given serious thought to his financial future. How strong could he make it? I still wasn’t sure, but I intended to find out. “Let’s say you can’t keep up the 20% return, and over time you get exactly the 15% you’re aiming for.” I pointed to the laptop. “What does your little calculator say would happen to that same $100 investment over those 60 years?”

“Let’s see…It says the $100 investment would grow to $438,399.” Dylan swirled on his barstool. “Oh yeah, and 87 cents.”

“Four. Hundred. Thousand. Dollars?” I crushed black pepper with each word. “How is that possible?”

“Einstein said, ’Compound interest is the 8th wonder of the world, he who understands it, earns it; he who doesn’t, pays it.’ That’s why you want to start your money compounding as early as possible. It’s also why you want to be extremely careful with debt. Your school loans and credit card balances are also compounding, just not in your favor.”

I’d never given much thought to the interest on my school loans or even on my credit cards. Just about everyone I knew paid interest on these; I’d just accepted them as a normal cost of living. “At least my school loans are super-low interest. I’m only paying 6%.”

“It may sound low, but it adds up over time. And the biggest cost is a hidden one.”

“What’s that?”

“All that money that’s going into your loan payments is money you’re not using to build your Cash Machine. You may only be paying 6%, but if you weren’t paying out that money, you could be investing it and watching it compound in your favor.”

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