A while ago I published an article on how compound interest helps young investors become extremely wealthy over time. This investment potential is something I want to explain further today.
Your Investment Potential
If you just start investing, you might not know or care about your investment potential. That’s a shame since it definitely matters. Think about your goals for a second.
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If your goal is to retire with a million euro portfolio, it matters a lot when you start and how much you can save every month. If you’ve got 40 years before you need your million euros, I’m confident that you’ll get there. If you need it in ten years, you need some damn strong savings to support this growth.
Let’s assume that the average, long-term expected return on any investment (a mix of stocks, bonds, real estate, alternative investments) is 7%. It doesn’t matter what you do, if the rate of return is equal, the only variables in determining your investment potential are your savings amount and for how long you keep saving.
Compound Interest and Investment Potential
It’s important to remember that compound interest is your friend. Especially over long periods of time, the effect of compound interest will easily outgrow your savings rate. Compound interest works right from the beginning, but when you just start out the returns you’re getting are likely small: 7% of your small portfolio.
But as your portfolio becomes larger, the growth from compound interest will start to catch up and even take over the growth coming from the savings you’re putting to work every month.
In general, I would say, the longer your investment horizon, the more compound interest will determine your investment potential. The shorter your investment horizon, the more your savings will determine your investment potential.
In any case, you have to keep saving!
You have to keep saving to maximise your portfolio over time. Every month, keep squeezing your budget, both on the cost side as well as the earnings side, to increase the amount you can put into your investments.
The more you save, the more your investments can grow over time. Now, remember, compound interest will help you but only over longer time periods. Saving more will help you immediately. Every euro you put to work now is a euro in your portfolio. In 40 years from now, that single euro is spitting out more than 4 euros every year in interest! Amazing right?
So keep investing, and put that single euro (or many thousands of euros) to work.
Calculate your Investment Potential
Enough with these theories. We want to see some magic, right? Well, you’ve come to the right place. For this magic to happen, we need to understand some of the math behind investing with compounding interest.
Calculation 1 – One-time Investment
The easiest calculation is the one-time investment. In this calculation, there are just three variables. You need a starting balance (your one-time investment), the expected rate of return, and the number of years you’ll be letting this money compound.
The future value (FV) of your investment (P), investing for (n) number of years at rate (r) is:
FV = P * (1+r) ^ n
With our known rate of 7%, we can just plug in the value of our initial investment and the number of years and know the future value. I want to create this example with a
The formula will look like FV = 10,000 * (1+0.07) ^ 40. The result is 149,744 euros. Amazing!
Now I want to know how my monthly contributions will grow over the same timespan.
Calculation 2 – Monthly Investments
Since our fictional example is a person who’s an avid reader of Fire The Boss and other amazing personal finance blogs, they are not only investing their first 10k but also adding money to their accounts monthly.
Let’s assume a nice middle-of-the-road figure of 500 euros per month invested or 6,000 per year. Some people might invest less, but grow this over time, some people (like myself) are aggressive and invest more.
The formula for the future value (FV) of a series of investments (P) for (n) number of years at rate (r) is:
FV = P * (((1+r)^n – 1) / r)
This might look a bit more difficult but it really isn’t. Let’s fill in our numbers (6,000 per year, 40 years, 7% per year) and see what happens:
FV = 6,000 * (((1+0.07)ˆ40 – 1) / 0.07 ) = 1,197,810 or close to 1.2 million euros!
Calculation 3 – Monthly Investments with Starting Balance
Of course, to get our true investment potential we have to add the two results from above together and we learn that we probably have somewhere around 1.35 million euros if we invest 10,000 right now, and then 6,000 per year for 40 years.
I will run the calculation for my personal numbers, just to give you an example of what I’m trying to do here.
My goal is to fire the boss by 40 years old. That leaves me with another 14 years to go (that’s short, I know).
Assuming I can put in 15,000 per year, and my current balance being around 60,000 euros, I should have the following calculations:
FV = P * (1+r) ^ n = 60,000 * (1.07) ^ 14 = 154,712 euros.
FV = P * (((1+r)^n – 1) / r) = 15,000 * (((1.07) ^ 14 – 1) / 0.07 ) = 338,257 euros.
Adding them together to find my investment potential gives me a total of close to 493,000 euros. Looking at that number, I’m not going to make my goal of financial independence by 40.
Maybe I have to work another few years, which isn’t bad at all, maybe I have to up my savings by a lot, which is also possible since I will probably increase my income some way or another – freelancing being the most logical next step for me.
What is your investment potential? Please run your numbers through these calculations and let me know in the comments below.