Many people dream of winning the Lottery. Some play almost a lifetime. As people are having difficulties to estimate probabilities correctly, this may be the main reason why the lottery is so popular. The chance for example of winning the Swiss lottery is 0.0000064% or 1:15.7 million. Yet there are safer ways to make a million. If you want to find out how it works, I'm glad to show you something that may help in this article.
Compound interest was described by Albert Einstein as the eighth World Wonder. I took the pleasure of preparing some calculations that demonstrate the incredible effect of compound interest on wealth accumulation. The recipe for one million seems to be "simple":
The impressive wealth development with the above-mentioned "ingredients" is shown in the following chart. While the savings component does not even reach the mark of 200'000, the compounded interest effect contributes to reaching the 1'000'000 mark.
Here too, the devil lies in the detail and implementation. The basic requirements to reach a starting capital of 10'000 and to put 500 per month aside are probably the more simple ingredients.
The second hurdle is to earn 9.35% per year. Let me come back to the comparison with the lottery millions: In my opinion, the probability of achieving a 9.35% return on investment is much more intact than to hit the jackpot. Taking into account that there is a probability of 1:15.7 million or just 0.0000064% to hit the jackpot.
From my personal experience, however, the biggest challenge is to maintain patience. Thirty years seem to be a long time. However, some people play the lottery for 30, 40 or even 50 years in order not to win millions. That also occurs to me as a rather extended time horizon. In my view, this has nothing to do with "becoming rich quickly".
Nevertheless, the required return and the necessary investment duration can be positively influenced if you increase the starting capital or the savings ratio. In the examples below I have made a few calculations to illustrate how this may look like.
One method of increasing the compound interest effect is to increase the starting capital. The more you invest at the beginning, the lower the return has to be.
|Starting Capital||Yield Needed*|
*for 1'000'000 in 30 years with annual savings of 6'000.
With an unchanged return, a higher starting capital reduces the investment duration to reach the goal.
|Starting Capital||Time Needed*|
*for reaching 1'000'000. - with a yield of 9.35% and annual savings of 6'000.
The following chart shows how the time needed is reduced by eight years with a starting capital of 100'000 as opposed to 10'000. It is even more impressive to observe what happens when you look at the development after the 22 years: the assets doubled within seven years to more than 2'000'000 - and after a total of 30 years they amount to over 2'200'000.
Saving 6'000 a year equals 500 per month. Of course, it is not possible for everyone to increase the savings portion to 20,000.00 per year. Therefore, I included four levels in the following table.
|Annual Savings||Yield Needed*|
*for 1'000'000 in 30 years with a starting capital of 10'000.
If the return remains constant, higher savings shorten the investment duration in order to reach one million.
|Annual Savings||Time Needed*|
*for reaching 1'000'000 with a yield of 9.35% and a starting capital of 10'000.
With higher savings, the required investment duration or return can be reduced considerably. The chart shows the calculation with a savings amount of 20'000 per year.
The higher the savings, the greater the compound interest effect. This also applies to smaller amounts. For example, if you start today with a starting capital of 0 and put 100 per month to the side, you will have 1'200 at your disposal by the end of the year for investing purposes. Should you repeat this every year this would result in 173'436 provided you use the same investment period and return. I would not consider 173'436 to be a small amount. Particularly not when you consider that the savings portion only amounts to 36'000 over the course of 30 years.
The more often compound interest is repeated, the higher the growth in assets will be. The investment period or the number of years determines how high the asset growth is or how high the return must be in order to achieve your goal.
*for 1'000'000 with a starting capital of 10'000. - and annual savings of 6'000.
While a return of 17.25% seems almost utopian and a return of 9.35% is considered ambitious, returns of 5.95% and 4.10% are considered more realistic in the long term. Nevertheless, there are investors who have made use of the compounded interest rate and generated high returns over decades. One of these is the investor Warren Buffett with an average annual return of around 20%. His assets have now grown to almost unimaginable 78.7 billion USD.
*with a starting capital of 10'000, a yield of 9.35% and annual saving of 6'000.
With a consistent return, assets develop considerably with an increasing investment duration. While the difference between 20 and 30 years amounts to an impressive 632'832, it is even more impressive between 40 and 50 years. Although the difference in terms of additional years is still 10, the wealth accumulated within 50 years is 3'781'503 higher than within the previous 40 years.
The core element and prerequisite for asset growth is the interest rate at which assets are compounded. The higher the compound interest rate, the sooner the originally defined target of 1'000'000 may be reached.
|Compound Interest||Time Needed*|
*with a starting capital of 10'000 and annual savings of 6'000.
Should you succeed in generating a return of 20% over 30 years, the amount of 10'000 would turn into over nine million. This is only possible due to the incredibly steep yield curve.
|Compound Interest||Wealth Accumulation*|
*in 30 years with a starting capital of 10'000 and annual savings of 6'000.
For the following chart, I used an example with a yield of 20%. It is impressive to see how tiny both the starting capital and savings become in relation to the compound interest effect.
Due to the compound interest effect, it is far more likely to reach one million with investments in securities than to hit the jackpot in the lottery. At the beginning of your professional life, the starting capital or savings share may not be quite as high. On the other hand, you have an incredibly long investment horizon that positively influences the compound interest effect. After a few years in your professional life, both the starting capital and the annual savings are likely to have increased.
The calculations also show, that a shorter investment period can be compensated for. If you are close to or after retirement, the investment horizon may not be as long as at 25, but the initial capital should be considerably higher.
Thus, there is a similar distribution of opportunities to take advantage of the "eighth World Wonder". It is crucial that the investment objectives and the desired return match your life situation.
As an independent financial advisor and asset manager, I am happy to answer your questions regarding financial topics. If you are interested in a topic, please send me a short e-mail or contact me directly via the button below. I will answer your questions personally.