Did you know that you can use your money to make more money? How does putting even a small amount into an account that accrues compound interest help you grow your money?
In his book The Psychology of Money, Morgan Housel discusses the power of compound interest. The key to maximizing your returns, Housel explains, is to invest as soon as possible and let your money grow over time.
Here’s why compound interest is the best way to maximize your income and build wealth.
Take Advantage of Compounding
The longer you invest, the more money you make because returns compound—that is, they build on previous returns to make ever-increasing returns. Housel recommends that you take advantage of compounding by finding investments that return solid, consistent results over time. He argues that ultimately, this strategy will make you the most money.
He argues that because of the power of compound interest, how long you invest is the most important factor determining your investment success—even more than other factors that seem intuitively important, like your annual returns. Housel illustrates this point with the stories of James Simons and Warren Buffett. Hedge fund executive James Simons is arguably the world’s best investor: Since 1988, his annual returns have compounded at 66%—three times the rate of Buffett’s investments. However, Buffett is 75% wealthier than Simons. This is because Simons only started achieving his 66% rate when he was 50, while Buffett has been earning 22% a year since he was 10 years old. Buffett is wealthier not because he’s a better investor, but because he’s been investing for much longer.
(Shortform note: Buffett and Simons are also good examples of the difference between what journalist David Epstein calls specialists, who master one professional field, and generalists, who have broad competence in many professional fields. Buffett has been investing his entire life; Simons had a successful career as a mathematician and codebreaker before embarking on an investing career in his 40s. In Range, Epstein suggests that being a generalist is a more reliable path to success than being a specialist. But the stories of Buffett and Simons prove that you can achieve success both ways.)
Housel contends that people often ignore the power of compound interest because it’s so counterintuitive: Even when you know compounding works, it’s still hard to imagine that unimpressive returns lead to impressive numbers just because you waited. As such, we try to achieve impressive numbers through methods that intuitively seem better—like finding the investments with the highest annual returns—even though they don’t work as well as compounding does.
(Shortform note: Why is compounding so counterintuitive? Psychologist Daniel Kahneman explains that humans are notoriously bad at questioning what evidence might be missing. So even if we logically know that how long you invest matters more than how much an investment returns in an individual year, we struggle to conceptualize and act on this information because we can’t see the numbers in our bank account 50 years from now.)
|When You Invest Matters, Too|
Interestingly, an article Housel wrote in 2014 adds a nuance to the idea that how long you invest is the most important factor in your investment success: He describes how, while how long you invest matters, the specific years in which you invest still significantly impact on how much money you gain over time. For example, someone who invested $500 in the S&P each month would have earned nearly $400,000 if they’d done so in the 20 years between 1980 and 2000, but only $60,000 if they’d done so in the 20 years between 1962 and 1982. This only applies if you invest little by little, not if you invest a lump sum at once.
To avoid a similar fate, Housel recommends strategies similar to those we’ll learn about in Lesson 10: Diversify your investments to reduce the risk of all your assets having a bad year, and make sure that you have enough flexibility with your money to, for example, let it compound a few years longer if you retire in a bear market.
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Here's what you'll find in our full The Psychology of Money summary :
- Why the key to financial success lies in understanding human behavior
- How to make better financial decisions
- How chance plays a bigger role in our financial lives than we think