I often talk about the power of compound interest in this column, and readers tell me they wish they understood the concept better.
Sonia writes: “In a savings account at the bank, you see the interest that is deposited every month. It’s clear. What is compound interest on the stock market? »
This is an excellent question, and I will answer it with a concrete example to illustrate the clickbait title of this text: showing how a parent can offer post-secondary education to their child by paying less money than for a subscription to cable, an expense incurred by 66% of Quebec households.
As university generally costs more than CEGEP, let’s hypothesize this path. At McGill, the most expensive public university in the province, and which is in the news these days, tuition fees for a Quebec resident can reach $7,500 per year, or $22,500 for three years. So, let’s assume that we need $22,500 per child from the age of 19.
As a parent, I have absolutely no intention of paying this amount with my salary. So I’m going to let compound interest pay the bulk of the bill for me.
As the quote often attributed to Einstein goes (although there is no proof that he authored it): “Compound interest is the eighth wonder of the world.” The one who understands it earns them, and the one who doesn’t understand it… pays them. »
Compound interest is simply interest on interest: its power multiplies over time.
It works a bit like a snowball that you roll into a snowman. As our ball gets bigger, its surface area increases and can attract even more snow. And so, after a few minutes, our mini-ball became a giant ball without much effort.
In finance, the same thing happens, but with money rather than snow.
Compound interest does not deploy its multiplier power after a few minutes, but rather after a few years, and especially a few decades – hence the importance of starting to invest as early as possible, even if you do not have large sums to start with.
Imagine that we buy a fund worth $100, and which will experience an increase of 10% per year in total growth, which includes dividends and the increase in the value of the fund (I chose 10% to take a round number, not because I anticipate this growth).
After one year, with 10% growth, our fund is worth $110. If we stop there, we made $10.
But if we don’t touch anything, and our $110 grows by 10% again the following year, we are at $121. Here, that extra dollar comes from growth over the $10 of growth from the previous year. This is the beginning of compound interest.
What is striking is that, as with the snowball, the increase in value accelerates over time.
At 10% growth per year, it takes a little over seven years to double our initial $100 to $200.
But then it takes less than five years to go from $200 to $300.
Then three years to go to $300 to $400.
Over the decades, this phenomenon gets out of control. After 50 years, at 10% per year, our investment is worth $11,700. Of this amount, $100 comes from invested capital, and $11,600 is growth resulting from compound interest.
Invest early
So, how can we pay our McGill bill effortlessly?
A diversified and balanced portfolio (60% Canadian, US and international stocks and 40% bonds) has produced an average annual growth of 8.46% over the last half century – which includes crashes, recessions , crises, COVID-19, Vladimir Putin, Donald Trump and the third link debate.
But for the purposes of our example, let’s imagine that the returns are less generous, and are more like 7% – hypothetical growth, because no one knows what the future will hold.
When a child is born, parents can go into their online brokerage account and invest $50 per month in units of diversified and balanced index exchange-traded funds (ETFs). I am thinking, for example, of the VBAL funds from Vanguard, XBAL from BlackRock or ZBAL from BMO.
After 19 years of saving and investing $50 per month at a hypothetical 7% annual growth, the parents realize that their balance is at $24,000.
Success. They can write a check to college and move on.
Of that $24,000, $11,400 would come from the $50 invested each month, and $12,600 would come from growth.
In other words, by starting early, and with small amounts, a bachelor’s degree can cost less than a cable subscription.
When it comes to compound interest, 19 years isn’t a lot.
Imagine that one parent starts saving and investing early in their career, say at age 25, ten years before starting a family. Not to pay for the education of an unborn child. Simply with the general aim of increasing one’s financial autonomy throughout one’s life.
In this scenario, with a hypothetical return of 7% per year, it is not $50 per month that it is necessary to invest, but barely $21.
When paying for studies, $7,250 in salary would have been invested over the years. Compound interest would have generated the remainder, $16,750.
Do you see why the idea that we must “deprive ourselves” to become rich is false? Over long periods of time, small amounts that have no impact on our quality of life can yield results that have enormous consequences on our quality of life.
To those who say that I dream in colors with a return of 7%, I just went to check, and the returns of the Registered Education Savings Plan (RESP) account which I take care of for 10 minutes per year in my brokerage account have been 11% per year on average for 10 years – and I’m not including here the thousands of dollars received in government subsidies (I know you’re interested in the question of stock returns. I’ll come back to that in the next weeks).
The difficult thing about compound interest is that from day to day it is invisible. Our investments can go up 1% one day, lose 0.75% the next, then lose 0.51%, and so on for months. We feel like we’re standing still. Or we become poorer.
It takes years of perspective to see the phenomenon of compound interest at work.
“The first rule of compound interest: never interrupt it unnecessarily,” American billionaire Charlie Munger likes to repeat.
The person who regularly invests in balanced index funds and then doesn’t pay attention to their investments may even realize one day that compound interest is generating more money than they are.
Imagine how your life would be different if you had an invisible worker by your side who made as much money as you.
Too good to be true ? For people who know the power of compound interest, it’s a reality.