The Magic of Compound Interest | WealthSmart

The Magic of Compound Interest


Share on facebook
Share on twitter
Share on linkedin

Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.

Part 9 of our Back to Basics Series

Albert Einstein basically created a whole new framework for physics and the concepts of space and time, so it’s only natural to pay attention to his thoughts regarding a fundamental principle of wealth creation, and its destruction!

Probably the greatest example of the power of compound interest lies in a fable about the day the inventor of the game of chess showed the game to an Indian King. Impressed by the game, the king wanted to reward the inventor. The brilliant inventor replied: “My wishes are simple. I only wish for one grain of rice for the first square of the chessboard, two grains for the second square, four grains for the third square, eight for the fourth square and so on for all 64 squares.”

The inventor had simply asked the king to double the amount of rice for each of the 64 squares. The king agreed to this seemingly reasonable and modest request. The week after, the king’s treasurer informed him that the reward would add up to a huge number and far greater than the rice that could be produced in many centuries.

The amount of the reward?

18 Million Trillion grains of rice!

The lesson here?

  1. Have a solid plan for investing.
  2. Start investing early.
  3. Don’t spend the earnings but reinvest them.
  4. Stick to your plan!

The Dark Side of Compounding

Although the term “Compound Interest” has been used for a long time, we need to address the elephant in the room: compounding at today’s prevailing interest rates will not get you ahead financially in the long run. Investing at 2% or so will not even keep pace with inflation, especially after taxes and is simply a path to “going broke safely.”

For your long term wealth creation, you need to decide right up front if you are an investor or a saver. Investors understand that short term volatility and risk is necessary in order to enjoy the rewards of superior long term returns. Great investors know how to best harness the rewards of investing and also manage the risks. Savers must generally work harder at saving because they do not have the stomach to weather the volatility and must settle on lower guaranteed returns.

Peter Westaway, chief economist and head of investment strategy for Vanguard Europe goes into some basic math on how bad things can get if we remain “savers” rather than “investors” Have a read through his article: “A ‘wonder of the world’ loses some lustre.”

Compounding can also get you into trouble if you spend more than you earn and get too deeply into debt, especially when you’re too busy seizing the day and ignoring your credit card balances!

To play with different investment scenarios, click here for our Savings Growth Calculator.