The Magical Beauty Of Compound Interest

No concept in in investing has ever held my respect like that of compound interest. When I first started reading up on personal finance and investing few years ago, I had a cavalier attitude on most of the topics I was fast learning about. Until it got to the topic of compound interest. Granted, I knew about Math but I don’t think they teach compound interest in high school the way we can picture it to be life changing. Especially when you can visualize it. Visuals make teaching a subject more meaningful to the students.

So when I was reading an investing book a few years ago and first saw the visual argument on the need to start saving and investing earlier rather than later (which conceptualized the topic of compound interest), I was sold on the time value of money. For compound interest to work, you need Investments + Time. The longer the time, the better for compound interest. It’s that simple. Over decades, the investment you put in is not going to be as important as the compound interest on your old investments.

I guess I have to backpedal first, for the benefit of those who don’t know, and define Compound Interest. This is interest earned on previously accumulated interest as well as the principal. When you’re investing or saving, this is the interest that you earn on the amount you deposit, plus any interest you’ve accumulated over time. Think of it as “interest on interest.” It will make your savings grow at a faster rate than simple interest, which is calculated on the principal amount alone. This is the single most important concept in investing.    

Granted, compound interest also work on debts you owe. A clearest example would be when you owe a private student loan of $400,000 and continue to make just minimum payments, over time, this loan could grow to $600,000. It’s all thanks to the ravaging effects of compounding on the loan at exorbitant interest rates. Think the numbers above are far-fetched? Well I know somebody it happened to! The same thing will happen with credit card debt. However for the purposes of this blog post, I’ll limit the discussion of compound interest only as it relates to investing.

Ben and Arthur

It was in one of Dave Ramsey’s book that I first saw the Ben and Arthur example. There are many different variables to this illustration from different authors, but the central gist is the same. Basically, the story shows the incredible power of compound interest. Ben starts saving $2,000 a year at age 19, stops saving at age 26, and never saves another dime. His brother, Arthur, starts later—at age 27—but saves the same $2,000 per year until age 65, almost his entire life. With a 12% return, guess who came out ahead at retirement?

This usually blows people away the first time they see this. It happened to me too. Yes, yes, I know the 12% return used in this illustration may be far-fetched (it’s Dave Ramsey, remember?) but you get the whole gist anyway.

The Magical Penny

Another version of this illustration is the Magical Penny. Here, it shows what happens to a penny when it is doubled daily. This illustration is usually prefaced with the question, “Would you take $1 million dollars today or a penny doubled daily for 30 days?” If you’ve not been schooled in the math of compound interest, you may dare to choose to take the $1 million dollars. After all, a bird in hand is worth two in the bush, right? But that would be the wrong answer. See below.

It’s remarkable that after day 15, the penny has doubled to only a paltry $163.84. Nothing remarkable about that. And by Day 22, it is at $20,971.52. But if you stuck with this experiment by day 30, it has grown to a magical $5.36 million. Remarkable. This is why there is a common saying in the Personal Finance world, that is often attributed to Albert Einstein which says that, “Compound interest is the 8th wonder of the world”. It really is a wonder when you factor in how money multiplies (compounds) over time, if you re-invest the dividends.

I’ve read a few books about Warren Buffet, arguably one of the greatest American investors. Warren started investing when he was only 11 years old. His story shows the remarkable effects of compound interest. At age 84, more than 99% of Buffet’s current wealth (about $82 billion) all came after his 52nd birthday. At that time, he was worth around $250 million dollars. Compounding has done an amazing job to his investment portfolio since then. Sure, you may not become a Buffet, but everybody who invests well, can also enjoy the effects of compound interest. But you have to start early and be consistent and persistent and then give it time.

Doing the Heavy Lifting

It’s easy to see how compound interest does the heavy lifting. Consider this example: If one consistently started saving and investing $1,000 monthly from age 25 to age 55, at 8% compounded annual return, he will have about $1.5 million after 30 years of saving. Of that amount, he only contributed $360,000, or just 25% of the final amount. 75% of the total figure (>$1.1 million) was from growth of the invested money. This is the effect of compound interest, which does the heavy lifting. And it underscores why one needs to start saving as early as possible.

Investing is exciting in the long term simply because of this magic of compound interest. It is why just putting your money in a savings account will never grow your money to meet your retirement goals. You have to save, and then invest the money. In fact leaving your money in a savings account is a losing proposition because of the effect of inflation, which averages about 3-4% annually. As at the time of this writing, the highest interest savings account in the US yields about 2.2%. It’s a no-brainer which one to stick your money in: a savings account or an investment account.

The Rule of 72

So how long does it take for you to see the effect of compound interest? It does take some time. So you’ve got to have some patience. You can use the Rule of 72 to get an idea. This rule simply tells you how many years it will take to double your money at a given interest rate. You do this by diving the interest rate into 72.

For example, if you have $100,000 in investments and you anticipate an annual rate of return of 8%, how long will it take for your money to double to become $200,000? Divide 72 by 8 and you get 9 years. Remember, this is if you’re not adding any more money to the pot. You can use any number and do this exercise. Let’s say you’ve been able to accumulate $1 million dollars in your investment portfolio and you just retired, so you can no longer add any money to it. If you are able to get 8% annual rate of return on that money (and assuming you are not withdrawing from it), in 9 years time, that $1 million will turn to $2 million without you lifting an eyelid. Isn’t that just wonderful?

Stay The Course

Basically you will notice compounding at work when your returns are far in excess of your contributions. This is the sweet spot. For different people, this will happen at different times. It is often said that saving the first $100,000 is the hardest. Beyond this point, it becomes easier as it takes shorter and shorter time for the next $100,000. So, all you have to do is get cracking and stay the course. In good times and bad times in the stock market, do not lose hope and do not bail. In time, you shall be pleasantly rewarded by this wonderful principle of compound interest. It does not discriminate. It is an equal opportunity principle. All you have to do is invest, have patience and watch it grow. It makes all savvy investors geniuses.

Wisdom of Benjamin Franklin

Perhaps I will end this post with the most beautiful story about compound interest that I’ve ever come across. Todd Grady reminds us of an actual case of compound interest involving Benjamin Franklin. Franklin was one of America’s founding fathers who helped draft the Declaration of Independence and the US Constitution. When he died in 1791, Franklin left a gift of $5,000 to each of his two favorite cities, Boston and Philadelphia. A stipulation of the gift was that the money could only be paid out at two specific dates: one hundred and two hundred years after the date of the gift. After 100 years, each city could withdraw $500,000 for public works projects. In 200 years, each city could withdraw whatever balance was left.

In 1991, after 200 years, each city received approximately $20 million! Isn’t that just amazing? Franklin’s point was to teach all of us in a dramatic way how powerful compounding can be. As Franklin liked to describe the process, the benefits of compounding are that, “the money that money makes, makes money”.

So if you haven’t started, today is your day. It’s never too late to start. If you need some help, you can get some primer here and here. Think you are too disorganized to save anything to invest? Well, here’s a quick guide to organize your finances. The best time to start investing was yesterday. The second best time is today. Don’t delay. Get crushing and start flexing the muscles of compounding to your advantage.

Does compound interest get you excited the way it does to me? Please respond below