Compounding

If you have $1,000,000 and plan to retire early on it, how much can you actually spend each year? Spend too much and you risk running out of money before you run out of time. Spend too little and you shortchange yourself for decades. Is there a withdrawal rate that is safe enough to last forever? There is. It is called the 4% rule. What the rule says Assume inflation runs at 2%. If your portfolio compounds at 6% a year, you can withdraw 4% of it every year without your capital shrinking. ...

If you earn 10% a year, what is your total return after ten years? Most people answer 100%. That answer is wrong, because it ignores compounding. The correct answer is 159%. The mechanism is simple. The first year’s gain takes part in the second year’s growth, and the second year’s gain produces gains of its own. The longer the horizon, the more dramatic the effect. Einstein is said to have called compound interest the eighth wonder of the world: those who understand it earn it, and those who do not pay it. So how do ordinary investors put it to work? Two things matter. ...