Compound-Interest-Albert-Einstein-2
Whether Einstein actually said this or not I cannot confirm, but I can attest to the fact that is it a truly profound quote. It succinctly summarizes the beauty and tragedy of compounding. If you understand and apply it, you will see enjoy its beauty. If not, you will suffer the tragedy well pass your desire to do so.

One of the components of the secret formula for financial success is time.  We will hold constant the scientific and philosophical nature of time. Let’s just all agree that it exists and as far as most of us know, it’s real and it has a significant impact on our lives. The other important component in the success formula is the rate of interest. Interest is the money earned on an investment or paid on a loan. It is the price of investing or borrowing.  As an investor, you want a high interest rate and as a borrower you would want a lower interest rate.

Now, the speed at which you can grow your savings is a function of both time and interest.   With a few exceptions, such as, writing a book about how to train your parrot and earning millions of dollars overnight as Frank Kern did. Most of us take a little longer to amass wealth.  Enter the magic of compounding.  Compound interest/compounding is earning interest on interest. Compounding allows you to generate more because your investment earns interest on interest. If you are able to invest over a long period of time and at a good rate of interest, you will experience the magic of compounding.  Compounding ensures that you maximize your savings, only if you don’t touch either the principal or the interest earned. In other words, compounding can only work effectively if you leave it alone.

Let’s assume that we have $10,000 in savings to invest.  Usually interest on investment is compounded annually.  Let’s see what happens when we invest this amount for different periods of time and at different rates of interest.

$10,000  for 20 years at 4%
$10,000  for 10 years at 4%
$10,000  for 10 years  at 8%
$10,000  for 20 years at 8%

Both the graph and the chart below demonstrate the magic of compounding.

 graph

If you invest $10,000 for 20 years at 4%, assuming you didn’t touch this investment over the period, it would grow to $21,911 without you any effort on your part. If, however, you invested the same amount at 4%, but for half the time, your investment would grow to only$14,802. If the $10,000 were invested for 20 years at a higher rate of interest of 8%, then your investment would have grown to $46,600. Saving $10,000 for only 10 years at 8% would give you almost the same as $10,000 invested for 20 years at 4%.

  table

Another way to say this is that if you were to invest $10,000 for 20 years at 8% interest rate you will have an overall rate of return of 366%.  In the worst case if you saved for only 10 years at 4% your overall return will be 48%.

What can we learn from this? The golden rule is: the earlier you start and the higher the interest rate, the faster your money will grow.

This works out well for you if you understand the beauty of compounding and you start investing early. But, what if this concept somehow eluded you?  No one ever took the time to teach you this either at home or at school. So in instead of having $10,000 in savings to invest, you instead had $10,000 in debt. Here is where you are on the wrong side of compounding.  First, the interest on debt is usually compounded monthly. The more periods of compounding the bigger the amount grows. This means that your debt will grow faster over time. Second, the interest rate on debt, namely credit card debt is higher than that on savings. So holding all other factors constant, your $10,000 debt with a 19% interest rate (I’m being generous here) for 10 years will cost you $65,871.14.  A $10,000 debt would cost you approximately 6 times its face value.

So on which end would you rather be?

The best time to take advantage of compounding is when you’re young.  When you’re just out of university, starting your first job. If you can start putting aside small amounts while at university, it’s even better. Generally, however, many young adults are not adequately trained in effective money management skills. So if we combine a lack of knowledge with the fervor of youth and ambition we end up with people who are busy having a life and not being bothered about issues like savings.  There is the sense that they can do it later. As such there is no urgency so the effort and discipline is not there.

Now, I am cognisant that many students are leaving school burdened with a lot of student debt. So it might be that the years following graduation are spent on clearing debt rather than on investing. Eliminating debt is crucial for your financial success. The faster you are able to get out of debt the faster you can work on wealth accumulation[i].

So regardless of the reasons why you may not have taken advantage of compounding in the past, there is nothing preventing you from doing so now.  Regardless of your age and level of savings there is never a better time than NOW.

Here are some practical steps to ensure you take advantage of compounding:

  • If you are trying to develop the habit of savings, stop over thinking it and just start, regardless of the amount that you have to invest. Just by making a conscious effort and moving in the right direction, will start to change your behavior and mindset.
  • Seek out reliable sources of information for where to invest. Sorry, but Google should not be your only source of information. Talk to your bank, your advisor or a mentor who has had success in investing.
  • If you have debt, start with a plan to reduce debt ASAP. As beautiful as compounding is, it is treacherous if you are on the wrong side. You want to get out of debt as soon as possible.
  • If you’re single make a commitment to yourself to either save or reduce debt and be sure to stick with it.
  • If you are married ensure that you and your partner on the same page. This is vital for your financial success.  Ensure that you are each aware of your money personality and take the necessary action to ensure that you can both achieve a common goal.
  • If you have kids/grand kids start teaching them core financial lessons. The earlier they learn and develop positive financial traits the more successful they will be in the future[ii]. It is much easier to teach a child good financial habits early on, rather than try to break bad habits later on. An ounce of prevention is worth a pound of cure.

I hope this proves useful to you. Be sure you are on the right side of compounding.

Question: If you could travel back in time and give some financial advice to your younger self, what would it be?

Dr. M

www.thekidonomicsseries.com

[i] I will discuss good and bad debt in an upcoming post.

[ii] Visit thekidonomicsseries.com for resources on teaching young children core economic and financial concepts.

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