One of the most important criteria for investing is the time you give your investment to grow. In particular, in order to let compound interest take effect, it is crucial that the investments made are carried out over a very long period of time.
The effect of compound interest:
In the following, the effect of compound interest will be clarified:
Imagine you invested an amount of $1,000 today and would achieve an average return of 10% annually on your investment. This would mean that in one year, you would increase the amount invested by $100 (10% of $1,000), to an amount of $1,100. If you had a return of 10% the following year, you would increase that amount by $110 (10% of $1,100). So after two years, you’d have $1,210. The compound interest effect would cause the original amount of $1,000 to grow to $2,593.70 after 10 years with an annual return of 10%. After 20 years the amount would grow from $1,000 with an annual return of 10% to $6,727.50, and after 30 years, up to $17,449.40.
Long investment horizon is more important than market timing:
In principle, it is impossible to predict in which direction the stock market will develop in the coming days, weeks or months. In the short term, developments on the stock market are often driven by speculation.
In the long term, however, share prices follow the company’s sales and profit developments. This can be illustrated by imagining that as corporate profits grow, the cake grows, which in turn can be distributed to shareholders. As the cake becomes larger, which can be distributed to the shareholders, the demand for the cake (or the company’s shares) also grows. The increasing demand for the shares then causes the price of the company’s shares to rise and investors benefit from this.
The S&P 500 stock index in variation in time:
The S&P 500 is a stock index that represents the stocks of the 500 largest listed US companies. The index is weighted according to market capitalization (the total value of the shares in circulation).
For example, if we look at the development of the S&P 500 over time, we find that it had to record strong price declines again and again (as at the time of the dot-com bubble in 2000, the financial crisis in 2007 or the Corona-Crash in 2020). In the long term, however, the index rises due to the long-term increase in sales and profit development of companies and the associated economic growth.
Long-Term Chart S&P 500
Source: Google Finance: https://www.google.com/finance/quote/.INX:INDEXSP?sa=X&ved=2ahUKEwiil57bk6f1AhUBIrkGHRWeAAsQ3ecFegQIDRAc&window=MAX
The importance of investing in companies that have long-term competitive advantages:
In order to be able to take advantage of the long-term effect of compound interest, it is extremely important to invest in companies that have long-term competitive advantages, because this increases the likelihood that the companies will be able to survive in the long term and that they will be able to continuously increase their sales and profits in the long run.