Compound interest is the most powerful tool in the investing world yet unfortunately only harnessed by a few. As Warren Buffett said:” Compound interest is the eighth wonder of the world”
You don’t need to do a lot to benefit from the logic-defying benefits of compounding interest. Warren Buffett didn’t become a billionaire until he was 50 years old. 99% of Warren Buffett’s net worth was earned after his 50th birthday. The real key to his success is TIME! That’s the secret! Build an investment account early and leave it!
Warren Buffet stated that: “My life has been a product of compound interest.” which is true as there are investors that did much better in terms of annual returns but nobody invested as long as he did.
A story to set the mood:
The story of Theodore Johnson is the perfect example of how compound interest goes to work overtime. Theodore Johnson, whose first job was with the newly formed United Parcel Service in 1924, worked hard and moved his way up in the company. He never made more than $14,000 a year, but here’s the magic formula: He set aside 20% of every paycheck and Christmas bonus and put it into company stock. He had a number in his head, a percentage of income he believed he needed to save for his family, and did it consistently over time. Through stock splits and good old-fashioned patience, Theodore Johnson eventually saw the value of his UPS stock soar to over $70 million by the time he was 90 years old.
Let’s dive into the mechanics of compounding interest to explore how it is so powerful. We will look at what compound interest is, show an example of compound interest and finally look at why people don’t harness compound interest.
What is compound interest?
When you invest a principal amount and it earns interest, the extra interest gets added to the principal, and the next term you earn interest on the bigger principal. This act of earning interest on interest is compounding interest and over time it creates a snowball effect.
A quick example:
You invested R10 000 and it grew by 10% for a year, its value is R11 000 at the end of year one. This R1000 gain is simple interest. If you reinvest the first year’s interest, the power of compounding will start. R11 000 x 10% = R1 100 leaving your investment at R12 100 after two years and so the snowball starts thanks to compounding interest.
Invest a large amount earlier:
A percentage on an extra zero changes the game. If you take 10% of R10 000 which is R1000, and 10% of R100 000, which is R10 000. It’s TEN times more. The more you save up to get to a bigger investment amount the more powerful compounding interest you will receive.
Total interest earned example:
If investor A invests R2000pm for 40 years growing at 10% per year the final value will be R12,648,159.16, but in the last year before the end, the investment value was at R11,426,521.87
Meaning the investment earned R1,221,637.29 in the last year alone! That is 9.6% of the total investment amount in the last year of the 40 years alone. As you can see this process should not be interrupted as compounding growth happens exponentially and is not linear. “The first rule of compounding: Never interrupt it unnecessarily.” Charlie Munger
Below is an example of investors A and B. Investor A starts saving early at the age of 25 and saves for 10 years. Investor B started later, at age 35, and saved for 30 years. When both investors turned 65, investor A invested a total of R240 000 and investor B invested R744 000, Investor A investment value at 65 was R12,879,287.82 while investor B’s value was R4,803,306.42. The example clearly illustrates that investor A contributes much less and has a bigger investment value than investor B all thanks to the superpower of compounding interest.
Why people don’t harness compound interest
Lack of planning:
Most people don’t leave their investment over long periods as life happens. With a financial plan in place, you can leave your investment to grow while having sufficient capital for emergencies and deposits, etc.
Most people only find out about compound interests later in life, if they ever find out, only a handful take action to exploit this superpower by starting to invest soon enough.
Remember that as amazing as compounding interest is, it works just as well with debt too. Compounding the debt as debt gets added to the principal debt amount. You have to get rid of all bad debt before you can build real wealth.
Greed and impatience are the enemies, investing is a marathon, not a sprint. Most investors get distracted by short-term noise and act on it when they should stay the course. It’s an addictive behaviour and makes you want to do something with your investment account, a recommendation would be to check your investment once a year! You mustn’t touch it. Your investment account can be viewed as a bar of soap, the more you touch it the smaller it gets.
Harnessing the power of compound interest is so easy yet so difficult. By ridding yourself of debt, starting to invest early, and staying invested over long periods, you will reap the benefits of compounding interest.