How to Make Compound Interest Even More Effective: Part 2

In my last post I talked about how to increase the effectiveness of compound interest through contributing every single year to a savings account and increasing the amount you contribute. In this post I want to bring up another powerful way to make compound interest more effective: contribute as much as you can early on.

Let’s look at an example to see the importance of contributing as much money as possible early on. Person A contributes $30,000 to their savings account in year 1 and year 2. Then, for the next 13 years they contribute $5,000 every year. Person B, on the other hand, simply contributes $5,000 every year for 15 years. Let’s assume each account grows at a 6% interest rate. Let’s see how our two people compare at the end of 15 years:

Year Person A Contribution Total $ Person B Contribution Total $
1                               30,000      31,800                                  5,000          5,300
2                               30,000      65,508                                  5,000       10,918
3                                  5,000      74,738                                  5,000       16,873
4                                  5,000      84,523                                  5,000       23,185
5                                  5,000      94,894                                  5,000       29,877
6                                  5,000    105,888                                  5,000       36,969
7                                  5,000    117,541                                  5,000       44,487
8                                  5,000    129,894                                  5,000       52,457
9                                  5,000    142,987                                  5,000       60,904
10                                  5,000    156,866                                  5,000       69,858
11                                  5,000    171,578                                  5,000       79,350
12                                  5,000    187,173                                  5,000       89,411
13                                  5,000    203,703                                  5,000     100,075
14                                  5,000    221,226                                  5,000     111,380
15                                  5,000    239,799                                  5,000     123,363

At the end of the 15 years, person A has over $116,000 more than person B in their savings account! So even though person A and B contributed the same amount during years 3 through 15, the simple fact that person A contributed far more in the first 2 years made all the difference. This example illustrates the importance of saving as much money as possible while you’re young and letting that money compound over time.

But What About Market Crashes??

But there’s one caveat to consider. What if you happen to invest a ton of money when you’re young like Person A, but then the market crashes? Lucky for you I ran the numbers on historical data going all the way back to 1960.Consider the following two scenarios:

Scenario 1: You contribute $20,000 to a savings account in year 1, despite whether you think the market is overvalued or not.

Scenario 2: You fear the market may be overvalued so you hold your $20,000 in cash in year 1 but then in year 2 you contribute $20,000.

The following table shows the 10 year return you would have had on your initial contribution of $20,000 in both scenarios.

Starting Year S&P 500 Return Scenario 1
10 Year return
Scenario 2
10 Year return
Scenario with higher return
2006 15.7%                 40,410                 34,915                                                      1
2005 4.8%                 41,802                 39,892                                                      1
2004 10.8%                 40,704                 36,730                                                      1
2003 28.7%                 39,564                 30,736                                                      1
2002 -22.3%                 26,539                 34,142                                                      2
2001 -12.0%                 22,886                 26,000                                                      2
2000 -9.1%                 18,108                 19,923                                                      2
1999 21.1%                 17,253                 14,246                                                      1
1998 28.7%                 35,378                 27,482                                                      1
1997 33.7%                 44,841                 33,546                                                      1
1996 23.1%                 47,677                 38,743                                                      1
1995 38.0%                 62,796                 45,498                                                      1
1994 1.2%                 57,339                 56,665                                                      1
1993 10.2%                 49,076                 44,546                                                      1
1992 7.6%                 67,935                 63,137                                                      1
1991 31.0%              101,069                 77,181                                                      1
1990 -3.4%              107,396              111,199                                                      2
1989 32.0%              117,053                 88,677                                                      1
1988 16.6%              106,060                 90,929                                                      1
1987 5.7%                 83,859                 79,344                                                      1
1986 19.1%                 81,133                 68,145                                                      1
1985 32.2%                 77,736                 58,784                                                      1
1984 6.0%                 81,400                 76,821                                                      1
1983 23.1%                 90,976                 73,886                                                      1
1982 21.2%              102,491                 84,550                                                      1
1981 -5.3%                 74,096                 78,267                                                      2
1980 32.8%              101,853                 76,720                                                      1
1979 18.7%                 91,583                 77,161                                                      1
1978 6.4%                 83,550                 78,518                                                      1
1977 -7.8%                 72,902                 79,052                                                      2
1976 24.2%                 76,049                 61,231                                                      1
1975 38.5%                 79,626                 57,509                                                      1
1974 -27.0%                 54,895                 75,148                                                      2
1973 -15.0%                 37,882                 44,583                                                      2
1972 19.2%                 37,235                 31,251                                                      1
1971 14.5%                 45,051                 39,332                                                      1
1970 3.6%                 35,156                 33,934                                                      1
1969 -8.6%                 27,063                 29,620                                                      2
1968 11.0%                 28,239                 25,433                                                      1
1967 24.5%                 38,108                 30,621                                                      1
1966 -10.4%                 27,504                 30,682                                                      2
1965 12.5%                 22,337                 19,864                                                      1
1964 16.6%                 35,651                 30,578                                                      1
1963 23.0%                 51,624                 41,957                                                      1
1962 -9.2%                 39,341                 43,327                                                      2
1961 28.5%                 44,139                 34,347                                                      1
1960 -0.7%                 42,290                 42,605                                                      2

In 35 of the 47 ten-year return time periods, you would have made more money by choosing scenario 1. That means about 75% of the time you would have made more money by just investing in the market as soon as possible and not trying to wait an extra year for the market to dip.

Why does this strategy make sense? It’s because most years the market has positive returns. So if you wait an additional year to invest, you’re most likely going to miss out on making some money. Obviously if you knew the market was about to crash it would be beneficial to wait an extra year to invest, but it’s nearly impossible to know when the market will actually crash. For example, from 1982 through 1999, the market only lost money in one year. So you would have been waiting a very long time for the market to crash to actually start investing, and you would have missed out on all those returns.

Key Takeaways

  • Contribute as much as possible early on – compound interest is extra magical when you give it plenty of years to work
  • Don’t wait for the market to crash to invest your money – you might be waiting longer than you think

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