Compound Interest Will Create More Millionaires by 2030 Than Any Other Strategy

Compound interest is when your money grows over time as investments gain value. Each time your portfolio goes up 1%, it's not just the principal that gains value. All of your unrealized gains also go up by an extra 1%.

For instance, a 10% return on $100 turns it into $110, which is an extra $10. Then, if you get the same 10% return the following year, your $110 balance turns into $121. Not only did the $100 principal increase, but the $10 earned in the previous year also increased by 10%.

This process mints many millionaires because they don't stop with a $100 investment. Some people put thousands of dollars into their portfolios each month, and that's when compounding starts to crush all of the other strategies for building wealth.

Image source: Getty Images.

Earned income has constraints

While it's great to look at compound interest, I believe it's more important to grow your income first. A higher income lets you put more money into your portfolio each month and introduce more financial flexibility.

However, there are limits to how much you can boost your earnings. While jumping from $50,000 per year to a six-figure salary within a few years is transformative, it becomes more difficult to make that jump in the future. For instance, it is very difficult to go from earning $100,000 per year to bringing in $500,000 per year before taxes. Even if you get there, getting from $500,000 to $2 million in annual earnings is even more challenging.

It is difficult but possible for a portfolio to go from $100,000 to $500,000, or from $500,000 to $2 million, without increasing the number of hours you work. A 5x return isn't easy to achieve either, even if you buy growth stocks. Furthermore, it could take more than a decade to get that type of return, but it doesn't take any additional time. Compound interest grows in the background, while you must remain active and work longer hours to boost your earnings.

Cost-cutting also has its limits

You can become a millionaire by reducing your living expenses. Someone who spends $5,000 per month can get much closer to their financial goals if they only spend $3,000 per month. When I first reviewed my credit card statements, I found several opportunities to cut back on costs, which freed up more money to invest.

However, I quickly came across a problem. No matter how much you cut costs, there is a limit. You still have to cover essentials, such as food and housing. You can save money by downsizing and eating rice instead of meat. Those are substantial quality-of-life hits that go far beyond skipping your monthly restaurant visit, and I wasn't willing to do them.

Even if you make these changes, you still need some type of food and housing. Someone who cuts everything else for rice to max out their savings still has to eat rice to survive. Similarly, downsizing to a 100-square-foot tiny home leaves you with few options for further reducing your housing expenses.

I stay on top of my expenses and don't want to spend recklessly, but cost-cutting is not the path to long-term wealth. Pursuing a higher paycheck will do more for you right away, but investing your earnings into assets that grow over time will yield more growth potential in the long run than an immediate salary bump.

AI tailwinds could fuel a multi-year rally

Compound interest has helped many people reach millionaire status, and it may be more pronounced amid the AI build-out. Stocks like Micron and Sandisk have minted new millionaires over the past year. Micron has more than quadrupled over the past year, and Sandisk is up by roughly 800% over that stretch.

Not every tech stock achieves those types of returns, and you won't get those types of gains if you exclusively invest in an index fund. However, many of the same stocks that benefit most from artificial intelligence are also large positions in key indexes like the S&P 500 and Nasdaq Composite.

The S&P 500 has an annualized return of 22.9% over the past three years. If that rate of return continues for the next five years, a $500,000 portfolio would grow into $928,166.

That's an extra $428,166 over the next three years, averaging $142,722 per year. It assumes a generous 22.9% annualized return, driven by AI tailwinds, and also shows that compound interest works best for people who already have large portfolios. However, it still works well for anyone who invests, and the more money you invest now, the more powerful compounding becomes in the future.

Marc Guberti has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Micron Technology. The Motley Fool has a disclosure policy.