What is compound interest and how can I benefit from it?
Philip Fletcher | Director & Co-Founder
One of the key reasons Pynksters are joining our community from around the world is that Pynk is a fun and engaging place to learn about finance. Later this year you will see product releases in our ‘price prediction tool’ that are designed to help Pynksters become better long term investors. In this way, Pynksters are ‘learning by doing’ in a fun, engaging and risk free environment. More on that to come!
To supplement this — well it’s key to share our financial expertise with our community and crowd. This year, through our blogs and articles, we are kicking off our campaign for ‘real financial education’. We believe there are many untold truths when it comes to investing, finance and both macro and microeconomics.
One of the questions I hear asked often by Pynksters is ‘what is compound interest and how can I benefit from it’? Here I’ll show you a super basic example to help you understand the incredible effects of this ‘gift of the financial gods’!
Let me first indicate its importance with some notable commentary on the subject from the likes of Einstein (as cited by the Wall Street Journal) and Warren Buffet;
All I can do is remind them of the truth of Albert Einstein’s alleged response when he was asked, “What do you, Mr Einstein, consider to be man’s greatest invention?” He didn’t reply the wheel or the lever. He is reported to have said, “Compound Interest.”
“My wealth has come from a combination of living in America, some lucky genes, and compound interest” — Warren Buffett
The concept of compounding is arguably the most underrated power in the world. It means many different things depending on context, but essentially, the end result is an increase in your annual returns, thanks to earning interest on your interest. Ultimately, this helps your rate of return grow faster over the compounding period.
The good news is there are only a few things you require to enjoy compounding interest. First start saving! Secondly, choose an investment that generates a return (e.g. interest rates or shares that payout dividends). Finally, you’ll need just a little patience.
The power of compound interest means different things to different people. Historically, compounding your power would mean accumulating more land, giving you more and more control and the ability to make larger moves, meaning the simple farmer can become a Lord. It is fairly common now in the Real Estate industry. Property investors start with one house and after 10 years, 20 years and 30 years are in control of numerous; leveraging continuous compounding to make larger and larger purchases, increasing their rate of returns and net worth. The simple concept of compounding considers how accumulation can very quickly alter your reality.
So let’s take an age old fable, and relate this to you…
When the inventor of a game showed it to the emperor of India, the emperor was so impressed that he asked the man to name his reward. The man responded,
“Oh emperor, my wishes are simple. I only wish for this. Give me one grain of rice for the first square of the chessboard, two grains for the next square, four for the next, eight for the next and so on for all 64 squares, with each square having double the number of grains as the square before. “
The emperor agreed, amazed that the man had asked for such a small reward — or so he thought. After a week, his treasurer came back and informed him that the reward would add up to an astronomical sum, far greater than all the rice that could conceivably be produced in many many centuries!
This simple example shows you just how extreme compounding interest can be! So, let’s replace rice with money.
Calculating compound interest is easy enough, with the annual interest rate ‘r’ (sometimes referred to as simple interest rate) received being a key factor.
The formula for calculating compound interest is P = C (1 + r/n)nt — where ‘C’ is the initial deposit, ‘r’ the interest rate, ’n’ is how frequently interest is paid, ‘t’ is how many years the money is invested and ‘P’ is the final value of your savings.
If you are not that familiar with equations, you do not need to worry about trying to plug in all the numbers yourself, as several tools exist online that can do it for you.
Now imagine you have $100, you invest that $100 and get a solid return of 10% year on year. You also contribute regular monthly deposits $100 a month to turbocharge that interest curve…can you estimate what that $12,000 turns into over 10 years?
You end up with a staggering $22,526.30 at the end. That’s almost doubling your net worth in just 10 years without having to lift a finger. Not bad! It’s also interesting to look at the interest curve (interest earned). Let’s take a closer look……
You notice how initially the line is fairly stable, but as your money begins to compound, the impact on this curve is dramatic. Remember how I mentioned ‘Turbo Charging’ your savings with regular deposits? That is what causes that line to really start working for you.
A useful way to encourage yourself to save that extra dollar or two, is to consider this interest curve. Where you may spend $3 on a coffee, that $3 very quickly becomes $0. But, if you add it to your savings, and take advantage of that interest curve, that $3 is actually worth $8.51…
That means, the coffee has actually cost you $3 + $5.51 in lost potential gains (referred to by economists as ‘opportunity cost’)…
Doesn’t seem like much, but imagine you buy 10 coffees a month…that becomes a cost of $30 + $55.09 in lost potential gains…per month!
Something tells me you can do a lot more with $55.09 dollars gain per month instead of spending it on expensive coffee…
If you want to educate yourselves further about investing and how to make better investment decisions — then make sure to follow the Pynk blog this year as we build on our campaign for ‘real financial education’. If you want to learn from other Pynksters in the community checkout the new Pynk forum…feel free to post any comments or questions either there or below this article and I’ll be sure to drop by!
PF
Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.
