Do you know the simple yet hard route to becoming a millionaire?

Becoming a millionaire is not complicated, but it is hard. Here's what you need to do it.

So, you want to become a millionaire?

To become one, you’ll need these two things:

• Patience

• The ability to save some money every month

As we saw last week, time is the most crucial component of building wealth due to compound interest (or compound returns) and the effect of exponential growth.

We saw that the real secret to the success of legendary investor Warren Buffett was time, more so than his investing skills.

The ups and downs on your way to riches

We know the stock market is very volatile: there will be good and bad years, bull and bear markets. Consequently, by investing in it, you’ll have years where you’ll make good money and years where you’ll lose out instead.

Even with all those bad years in between, the net result of investing in a diversified index like the S&P500, in the long-term, has so far always been positive.

On average, investing in the stock market will make you about 7% each year. (This is an average that has been calculated on past returns of the S&P500, an index of the biggest 500 U.S. companies)

We’ll use that 7% to simulate our average return for calculation purposes.

Compounding your money

The average 7% return also means you roughly double your money every ten years.

That may seem slow at first, but it also means that in 20 years, you will have 4x’ed (2x2).

In 30 years, we’re talking 8x (2x2x2). See where this is going? Compounding needs time to show its powers.

Let’s assume you have €1000, and you invest it for 7% a year. Here’s what will happen to your money and how you can see the effect of compounding:

In the first year, you end up with €1070. So your initial 1000 + 70 is the 7% you made on your investment. Easy enough, right?

In the second year, you leave that entire amount, the €1070, in your investing account. And in the second year, you get another 7% returns. That means:

In year two, you have made an additional €74,90, which is 7% of the €1070 you had at the start of year 2.

Here, we see something neat happen. We are making more money than in the first year, even though we haven’t put any additional money into our investment account.

The first year’s return (€70) is now earning us a return on its own! The return of the first year is making us 7% of 70 = €4,90, for “free”!

As you can see above, we’ve split the €74,90 of year 2’s returns into €70 (returns over our initial investment) and €4,90 (the returns over our returns).

Yes, it’s only €4,90 in this example, but in year 3, that €4,90 will also generate its own returns, et cetera.

This is triggering exponential growth that is far from negligible.

In fact, over time, compound returns will be the most significant contribution to your wealth.

Far more than the money you manage to save & invest every month. It just needs time to show its power.

Let’s see what it could do over 40 years.

This is how powerful time and patience are

Let’s say you start at 25 years old and invest a certain amount each month for 40 years. We further assume making 7% returns, a yearly salary increase of 3%, starting with a salary of €40.000 and saving & investing 12% of that.

At the start, that means saving and investing about €400 each month, which will increase over time as you get raises.

Here’s what that will look like after 40 years:

After 40 years, we end up with 1,6 million euros. Quite a nice haul. How’s that possible?

Let’s dive into the charts.

Here are the first twenty years:

You can see our returns and compounding are barely visible at the start. This is because it takes time for them to get more powerful.

After twenty years, we are at a little over €280.000. Of that amount, about half is invested by us, and the other half is generated by returns (orange) and compound returns (purple).

Not a bad start. But still relatively slow.

Let’s fast forward another 20 years.

Now we can see the true power of compounding.

Of our total 1,6 million, almost exactly half of it came from compounding (49%). 28% came from direct returns (the first time taking that 7% return). So only 23% is the amount of money we’ve put in ourselves.

That is the power of investing and compounding in particular!

Imagine you had done this, but instead of investing, you had only kept your money in a savings account. You would not have 1,6 million, but just your saved amount of 377 thousand (plus any interest you’d have gotten in a savings account). What a difference. (We ignore inflation here for both scenarios)

Why it matters

Time is the single most important thing when it comes to building wealth. We have seen how much of a difference it is to start early and have the patience to let compounding work its magic. Unfortunately, many of us only discover this too late in life. You know it now. Use it to your advantage, and start today!

I’ll be making guides on how to get started with investing soon. Drop me a reply if you’d like to receive one 😉

Cheers,

Jonne