Compound interest — The Eighth wonder of the world
Albert Einstein famously said:
“Compound interest is the eighth wonder of the world”
…but why? The answer lies in the surprising results that can be provided by compound interest over time.
Simple interest refers to situations where interest is paid only on the original principal amount, so for example if the principal is $100, interest is always calculated on the original $100. At an interest rate of 10% the amount would pay $10 interest in the first year, and $10 again in the second year, and so on.
Compound interest on the other hand pays interest on the original principal plus any interest already paid. So, using the example above (ie interest rate is at 10%), interest in the first year is $10. However in the second year interest would be paid on the original $100, plus the previous interest of $10, meaning interest would be paid on $110, giving interest of $11.
Extending the example further, have a look at the chart below:
Amazingly, at compounding interest of 10%, the balance doubles in a little over 7 years!
What is the relevance to shares?
Shares in many cases pay dividends — and dividends can be thought of as a kind of interest. Of course not all companies pay dividends, however on average dividend yields (the dividend paid as a % of the share price) are currently:
Australia (Top 200) 4.4%
United Kingdom (Top 100) 3.5%
United States (Top 500) 2.0%
Re-investing these dividends in either the same or other dividend stocks will result in the same effect as compound interest.
So how do I find these dividend paying stocks?
To assist you in finding a dividend stock Simply Wall St have created a new view: Top Dividend Payers.
This view only looks at stocks that have passed all 6 checks on the income axis of the snowflake. For example if we look at this view on the UK market one of the companies is Berkeley Holdings. Going into the infographic we can see the dividend yield for them is 7.58%.
A potential nice long term earner.
Additional thoughts
The tax treatment of dividends received by investors varies in each country, however dividend income is usually treated concessionally ie taxed a a lower rate than other forms of income. This adds to the overall appeal of dividends versus other forms of interest bearing investment.
The takeaway
We at Simply Wall Street have consistently said that investment decisions should not be based on dividends alone. However as you can see from the results, dividends can add significantly to overall investment performance, and indeed can be a bit of a wonder!
