Among the most important concepts an investor must comprehend is compound interest. While the idea is simple, the math can get complicated. The concept is straightforward, though, even though it is definitely not intuitive. In the end, the compounding of returns means that there is far more at stake in your various investment decisions than you may realize at first glance.
Here is the concept that lies behind compounding. Assuming that any return on an investment is reinvested, rather than taken out and spent, future returns will reflect not only earnings on the original investment but also earnings on the earlier returns.
Let’s use a simple example to illustrate. Furthermore, so that we can work with high interest rates, let’s put ourselves back in the year 1981. Imagine that you opened a bank savings account that year and it paid interest at a rate of 10% per year. After one year, your account would contain $110 (the original amount plus the ten percent earnings). The following year you would earn 10% on the balance in the account – but that is no longer $100 but, rather, $110. So the interest you would earn in the second year is $11 (not the ten you earned the first year). Now you have $121 and the ten percent you will earn will be a bit more than $12. And so on.
Over very long periods of time, this compounding results in earnings that are almost miraculously greater than our intuition might suggest. The secret here is that the compounding is continuous; it just keeps growing and growing. As a result, certain investments can bring far greater long term results than we might expect before we sit down to do the math.
Indeed, there is a legend that Albert Einstein referred to compounding as the eighth wonder of the world and said, “He who understands it, earns it … he who doesn’t … pays it. In light of its importance for understanding investment outcomes, and its playful “shock value” when illustrated, lots of financial folks (honest brokers and hucksters alike) are fond of creating new ways to demonstrate its power.
Here is my contribution for today. To make a point, I decided to give my business partner Mary a gift that would compound over the twelve days of Christmas. The first day I gave her a quarter and told her that each day I would double the amount given the previous day. So on the second day of Christmas I gave her 50 cents and on the third day a dollar. Without doing the math, can you guess how much I gave her on the twelfth day? OK then, do the math. The answer is $512. Rather than stopping on the twelfth day of Christmas, I had wanted to keep going for a month. It turned out, though, to be a little bit beyond my means.
Consider this, though, and help me decide. What if I gave her a penny on the first day of the month and doubled the gift each day until the end of the month? Do the math and let me know if it would be a good idea. I am at: firstname.lastname@example.org