Building a compounding machine is an incredibly important part of achieving financial independence, but not everybody understands how to get started, or even what the concept translates to in real terms.
Let’s imagine you have a black box. Your job is to earn and save as much money as you can. You put your money into your box - into your “compounding machine”. Once you put the cash inside the box and close the lid, the magic starts to happen.
Inside that box, your money starts to grow prodigiously. You start with a few thousand pounds and end up with hundreds of thousands, maybe millions.
If you’re a bit lazy (and who isn’t?) but still want to get rich (and who doesn’t?), then this is the path for you. We want our money to do as much of the work as possible for us. Yes, we are going to have to save hard, but the earlier we get started, the more of the heavy lifting that compound interest can do for us.
What powers the machine?
The results generated by your compounding machine will be driven by:
- The % of your after tax income you put into the box
- How quickly you get the compounding machine started
- What asset allocation (i.e. the mix of assets) your compounding machine runs on
- The fees that are taken out of your box
- Which fund(s) you choose.
All of these elements are important, but please note the order I’ve put them in.
The savings rate is vital. At a 50% savings rate, you’ll go from broke to financially independent in about 18/19 years. But, at the start of your journey, the most important thing is just to save something (anything) every month. The point is to get into the habit of saving every month, regardless of the amount. Pay yourself first and invest on auto-pilot.
If you’re wondering when to start, the answer is simple: if the best time to plant a tree was 20 years ago, the second best time is now.
Kate’s compounding machine
To illustrate the power of starting early, let’s take the example of Kate: a bright school leaver who gets a job aged 18. Kate does not go to university, gets a job, avoids student debt, and is able to start saving after six months.
Over the next seven years, she learns how to work hard, deal with people and use basic arithmetic. She doesn’t spend all her salary within a week of getting paid: instead, she saves, paying herself first every month, setting up a direct debit to stash £167 per month for a total of £15,000 over that period.
Kate directs her monthly savings into a low cost equity index tracker, saving £2,000 per year until age 25 when she stops making contributions into her pension and never saves another penny. Kate does nothing with her pension for the next 40 years and, as a result, Kate gets the same annual return (~10%) as the S&P 500 has done over the last 100 years or so.
At age 65, Kate fires up her laptop and is pleasantly surprised to see that her £15,000 of contributions have grown to just over £1 million. Inflation may mean that a million pounds isn’t worth as much as it used to be, but still, it’s not too shabby! You can check out the maths for yourself here.
So, what does that all look like?
Market predictions are a waste of time
It’s traditional at this point for someone to question whether 10% annual returns are realistic in future. We won’t be playing that game here: no one has a crystal ball and no-one knows what future returns will be.
The bear case sounds smarter, perhaps because in most areas of life, smart and sceptical people often do better. That said, there are no IQ prizes in investing. A 10% a year return from a stock market tracker fund achieved by a person with average intelligence beats a 2% return from a complex multi-asset approach achieved by someone who went to Harvard (someone should really tell hedge fund investors that).
When it comes to predicting future returns, there are two types of people:
- Those that don’t know
- Those that don’t know they don’t know.
What we do know is that, using The Rule of 72, the money inside your compounding machine will double every nine years at an 8% annual rate of return. At a 10% rate of return, the money will double every seven years. The higher the returns, the quicker your money doubles in value.
Fuelling the machine
We need to choose the fuel for our compounding machine - just saving into a bank account is like trying to power a full size car on itty-bitty AAA batteries. The same applies to bonds: they can’t power your engine, they can only act as a store of value and a shock absorber.
Gold (or commodities more widely) can act as a store of value, but it doesn’t compound, it just sits there as an inert lump of metal – it doesn’t grow and it doesn’t pay an income. The same goes for cryptocurrency.
To power your compounding machine properly, you need to invest in wealth-creating assets: that means either the stock market or property.
The stock market is the easiest of the two, and it gets better every year as human beings get better at making stuff, using technology, and solving problems.
Once you’ve paid off any expensive debts you may have, the best thing to put in your compounding machine is a low cost global tracker fund (such as VWRL or VRXXB in the UK).
The J curve illustrates the huge and exciting opportunity - and also the problem.
The problem is that the first six or seven years are B – O – R – I – N – G. If you’re looking to invest simply to add some excitement in life, you’re looking in the wrong place.
When it comes to investing, it’s better to think like a gardener. Once you’ve planted your seeds, there’s no point digging them up and looking at them every week to see how they’re getting on. Be patient: the time always passes and the future always arrives.
Once you have your compounding machine set up correctly, it’s time to raise your hands and back away. Studies by online stockbrokers where they analyse the results achieved by their clients and often find that the ones that did the best were those that had died - and the category that did second best had forgotten their log in details.
It may sound like a small point, but one of the things I like about Vanguards ETFs (e.g. VWRL) is that dividends are paid every quarter, which can act as a regular morale boost and a reminder that your compounding machine is working.
If you’re naturally impatient, that’s fine - just channel your impatience into your career. Take a qualification, win clients, beat your targets, learn to sell. Make yourself more valuable!
Remember, everything compounds. If you’re doing it right, your salary, your knowledge, and your ability to solve problems should grow exponentially as you go through life. The more capital you have (not just money but social capital, reputation, ability to reach an audience), the more effective you become.
Do you really understand compound interest?
It’s important to understand the J curve, both objectively and emotionally.
Objectively, the maths is the maths. There’s no point arguing with it - that’s like arguing with gravity.
But you also need to understand it emotionally. Here’s the million dollar (or pound) problem. We’re monkeys, programmed to operate in the here and now. Our untrained brains are well-adapted by evolution to solve the problem of what’s for supper tonight, but they’re absolutely awful at focusing on the long term.
So you have to use your rational mind (the weakest part of the brain) to overcome your chimp brain. This is a bit of a David vs Goliath fight, but it's a fight that your inner David can win by carefully targeting his effort.
Here’s a powerful way to tell if you understand compound interest or not: people that understand compound interest, earn it. People that don’t, pay it.
Why you must get out of debt
Imagine that we could invest the money in our compounding machine and get annual returns of 23% per year. That means £10,000 turns into £20,000 in just over three years.
Impossible you say? Well, my credit card provider recently wrote to me informing me that the interest rate on any balances not paid off every month is 23%. So millions of credit card holders with debt balances have a guaranteed way to earn 23% a year.
If you’re reading this and have any credit card debt, you need to pay it off before anything else. Imagine you’re in a rusty pick-up truck in the Arizona desert with no aircon, stuck in reverse gear with the radio playing Country & Western music as you accelerate backwards towards the edge of the Grand Canyon. That’s how bad having credit card debt is.
I once received a call from someone asking me for financial coaching. They were telling me about their situation and said they had credit card debt - at which point I gently pointed out that I would not be taking money for coaching from anyone that had credit card debt. If you have credit card debt, pay it off first!
Why doesn’t everyone get taught this at school?
Given how important compound interest is, it’s baffling to me how few people understand it - and how few financial “experts” teach it properly. If schools taught life skills, they’d teach the power (and the maths) of compound interest, as well as the power in the aggregation of marginal gains.
If all personal finance journalists/writers were genuinely interested in spreading financial literacy, they’d major on this stuff rather than on coupon clipping and affiliate links.
If the media were interested in helping people, they’d major on this stuff, too.
No one else is coming to save you. If you’re reading this and haven’t got your compounding machine set up yet, this is an emergency.
This article was written in partnership with Barney Whiter of The Escape Artist.