The Motley Fool

13 Steps To Financial Freedom Step 1: Change Your Life With One Calculation

One simple calculation can change your life.  Albert Einstein called this deceptively simple formula the “greatest mathematical discovery of all time”.  We call it a road to financial independence.

What are we talking about?  We are talking about the miracle of compound returns.

It’s about interest.  Earning a slightly higher rate of interest on your money can make a huge difference to the amount of money you end up with in the long run.

This is how it works:

  • You earn some interest
  • Next year, your earn interest on that interest
  • The year after, you earn interest on the interest on the interest
  • And so on..
  • You become financially secure

Instead of setting aside the interest you earn, if you put it back to work, that interest will earn you interest.  The bigger the amount of money, the more interest this money will earn, and the more interest will get put back in.  Over the long term, this can really add up!

It can be a little difficult to explain this miracle using only words, so we will try to use some tables and charts.

Here’s how a single $1,200 investment grows over time in four different scenarios.

How a single $1,200 investment grows

Savings Account (0.5%) Central Provident Fund (2.5%) Certificate of Deposit (5%) Stock Market (9%*)
Initial investment $1,200 $1,200 $1,200 $1,200
5 years $1,230 $1,358 $1,532 $1,846
10 years $1,261 $1,536 $1,955 $2,841
15 years $1,293 $1,738 $2,495 $4,371
25 years $1,359 $2,225 $4,064 $10,348
30 years $1,394 $2,517 $5,186 $15,921
35 years $1,429 $2,848 $6,619 $24,497
40 years $1,465 $3,222 $8,448 $37,691

*Based on the stock market’s historical rate of return.

So you see, $1,200 can turn into nearly $40,000 over 40 years.  This was because you were earning interest on your interest over time.

Ok, but let’s be honest, $37,691 isn’t what it used to be in Singapore.  That’s not even going to be enough for a down payment on a HDB flat today.  But what if we invest $1,200 every year?

A more compelling table than the previous one

Savings Account (0.5%) Money Market Fund (2%) Certificate of Deposit (5%) Stock Market (9%)
Initial investment $1,200 $1,200 $1,200 $1,200
5 years $7,321 $7,695 $8,494 $9,674
10 years $13,596 $14,865 $17,803 $22,713
15 years $20,030 $22,782 $29,684 $42,775
25 years $33,390 $41,174 $64,200 $121,136
30 years $40,323 $51,829 $88,899 $194,211
35 years $47,432 $63,593 $120,423 $306,646
40 years $54,721 $76,582 $160,656 $479,642

This is where investing regularly can really help you build a tidy sum over time. By setting aside as little as $100 every month (or $1,200 every year) you are effectively putting your money to work straight away. You are unlikely to notice the money coming out of your bank account every month but you could be pleasantly surprised at how even investing small amounts can mount up through compounding over the years.

The amazing story of the Mississippi washer woman

Oseola McCarty was born in Mississippi, USA, in 1908.  For nearly 75 years, she lived in the same simple house, washing other people’s clothes for a living and putting whatever money she could into savings accounts at banks.

In 1995, Oseola made headlines when she donated $150,000 to the University of Southern Mississippi to establish a scholarship fund. “I just figured the money would do [scholarship recipients] a lot more good than it would me,” she said. It soon came out that this washer woman had managed to save nearly one quarter of a million dollars over her lifetime.

Time — a key part of the compounding equation — helped turn her small early investments into hundreds of thousands of dollars.

It could have been a happier ending

 As remarkable as the Oseola McCarty story is, the ending could have been a blockbuster.  After she died in 1999, one of her bankers wrote to us saying: “Time was able to turn even the modest returns of her early investments into hundreds of thousands of dollars.  If we had been able to introduce her to equities earlier, she would have left millions instead of thousands.”

While the amount you save and how long you save for are important, they are only part of the equation.

This might cost you hundreds of thousands of dollars

Typically, the more risk you are willing to take on (say, by investing in shares rather than a standard POSB savings account), the higher your potential return.  But some people just don’t like risk, they are willing to settle for  lower returns just to avoid it.  They keep all their savings under their King Koil, or look around for a fixed deposit savings account with the best deal (perhaps they get a free umbrella from the bank).  We think that’s a bad idea.  You are actually losing money if the interest rate you get is lower than the inflation rate.  Here at the Motley Fool, we believe that the best place for your long-term savings is the stock market.

Through the course of our 13 Simple Steps to Financial Security, we will show you how you can save and invest your money well.