Compound interest
Let’s start this journey with a bit of magic. This is the secret why everyone tells you to invest: compounding. Albert Einstein was one of the smartest people to have ever lived, and someone who had seen his fair share of natural wonders in the world of physics. Remember, he often imagined himself riding on a wave of light when trying to conceptualize the theory of relativity — a pretty smart chap. And yet, he was so impressed by compounding, that he declared “compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” I want you to earn it, not to pay it. So let me tell you a bit more about it.
The definition of compounding is the process by which you earn interest (returns) not only on how much you invested (the amount you invested at the beginning, the principal), but also on all the interest (returns) that you already earned on that initial investment. Compounding is interest on interest you earned in the past, or returns on returns that you earned in the past. Not 100% clear? No worries let’s see a concrete example.
Last year you had 100 US dollars. Since you invested that money, it earned you interest/returns. Let’s say you made 10% returns on it. It doesn’t matter if that was interest your bank paid you, or returns from your stocks portfolio. All that matters is that now, on January 1st this year, you have not 100, but 110 dollars in your account (100+ the 10% returns/interest you earned last year). So this year, you will have not 100 but 110 to invest in your account. And therefore this year, you will earn interest — let’s say 10% again, like last year, not on 100 USD that you invested last year, but on 100 USD that you invested, PLUS on the 10 USD of interest/returns that you made last year.
See this is what compounding is: interest earned on interest that you earned in the past by investing. So this year, 10% interest will be 11 USD, instead of only 10 USD. That extra 1 USD is the 10% interest you will make this year, on the 10% interest you made last year, or on the 10 USD you made last year — that is interest on interest, or compounding. If reading 1 USD makes you laugh, don’t laugh just yet.
Think about compounding as a magic lever that amplifies your efforts. Yes, you save money, and that money will be available to you in the future. Yes, you invest that money, and therefore you earn returns on it. Those returns will also be available to you in the future. But in addition to the money you save and the returns you earn on it, your returns themselves will accumulate, each month, each year, and earn returns… on themselves. This is the extra boost you are getting. While saving and investing are actions you need to take, compounding, or earning interest/returns on interest/returns you already earned in the past, is a passive action: you don’t have to do anything. Don’t touch anything at this level. Just let math do the work for you. It’s a little elf, working for you in the background. And like Albert Einstein, marvel at the results one day.
Doesn’t sound like much? Well this is where the magic is. Let me show you what 100 US dollars, that earns you a return of 6% per year, will do for you over time with compounding, and without compounding:
1. After 10 years, you would have 1600 US dollars is you invested without compounding, and 1791 if you invested with compounding — this is 12% more
2. After 20 years, you would have 2200 US dollars is you invested without compounding, and 3207 if you invested with compounding — this is 46% more
3. After 30 years, you would have 2800 US dollars is you invested without compounding, and 5743 if you invested with compounding — this is more than 100% more, or more than double
The beauty of this compounding is that once again, you do not need to do anything. What did I tell you about this hard working elf in the background, grinding and compounding interest for you? Now you see why Albert Einstein so marveled at compounding interest. It truly is a powerful force.
It is such a powerful law that scientists, mathematicians, statisticians, have marveled at it over the centuries, in their respective fields.
This is why investing your money, earning returns or interest on it, is so powerful over the long term.
Compounding works with time. That little elf in the background, grinds away, but needs many years and decades to really deliver for you. This is why the sooner you start, the better.
