“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein
Most people have heard about the seven wonders of the world; Great Wall of China, Great Pyramid of Giza, Roman Colosseum, Taj Mahal etc. However, none of them come close to approaching the true eighth wonder of the world. Here are some reasons why.
In the early 1600s, the American Indians sold an island, now called Manhattan in New York, for various beads and trinkets worth about $16. Since Manhattan real estate is now some of the most expensive in the world, it would seem at first glance that the American Indians made a terrible deal. Had the American Indians, however, sold their beads and trinkets, invested their $16 and received 8% compounded annual interest, not only would they have enough money to buy back all of Manhattan, they would still have several hundred million dollars left over. That is the power of compound interest over time.
And what about the legend of the inventor of chess? Apparently he was granted any wish by a grateful king, and asked to be rewarded with one grain of rice on the first square of the chessboard. The amount was then to be doubled on each successive square. The king agreed, thinking he would have to pay a few handfuls of rice. He was shocked to discover that by the 64th square — thanks to compounding — he would owe the inventor enough rice to carpet the entire planet!
Einstein called it the ‘eighth wonder of the world’. He was talking about compound interest, which supercharges our savings and investments. This applies to compounding return from investment by reinvesting the dividends we have into the stock market over a long period of time. In the long run, we’re talking serious dosh by reinvesting the interest/dividend we earn to earn more interest/dividend!
The longer we leave our money, the more powerful the compounding interest effect. So, the earlier we start saving and investing, the more we make from compound interest/dividend or profits from stocks.
The Amazing Rule of 72
Here is an easy rule we can use to work out how our savings or investments can grow with compounding return.
Just divide the number 72 by the compound rate. The result shows how long it will take for our money to double without further savings.
For example, take $100,000 that is earning 4% interest (after tax). 72/4 = 18 years
If interest rate is 6%, number of years to double is 72/6 = 12 years, etc.
Table 1 below shows the number of years to double an amount at various interest rate,
Table1: Number of years to double your money with various rates of return
|
Interest rate, % |
2
|
4
|
6
|
8
|
12
|
18
|
24
|
|
Number of years |
18
|
18
|
12
|
9
|
6
|
4
|
3
|
The Magical Power of Compounding
If rate of return is 4%, the initial amount of $100k will multiply to $200k in 18 years, and becomes $400k in 36 years, and $800k in 54 years as shown in Table 2 below.
Table 2: Ending amount in thousands with initial $100k
|
% return/Years
|
18
|
36
|
54
|
|
4
|
200
|
400
|
800
|
|
8
|
400
|
1600
|
6400
|
|
12
|
800
|
6400
|
51200
|
But debt can compound us too!
Compound interest also applies to debt – although not in a good way. Costs can compound too. The slower we repay a debt which charges interest, the more we end up paying back over time. Think about the compound interest for credit card debts with 19% interest, say for 10 years.
If you borrow $10000 from the loan shark at an interest rate of 6% a month, in 12 months, or one year, the amount you owe him is $20000. If you can only pay him in 2 years, you got to pay $40000. Don’t ever play play with “Along”, legal as well as illegal “Alongs”.
Saving for retirement
For a 24 years old young graduate just entering the job market, you have one very valuable thing out there when it comes to planning for eventual financial freedom, TIME. For him, “Start saving now” are the three most powerful words in personal finance.
If you start saving RM5000 a year starting at age 24 now, or less than 15% of the salary of a young graduate and increase your saving every year by 4% when your salary increases, and earning 10% compound annual returns, you would have accumulated RM2.2 million by the time you retire at 60. Figure 1 below shows how your saving grows from year to year in an exponential way.
But wait until age 45 to start saving for that RM2.2m and you'd need to sock away RM60,000 a year, or twelve times more.
With the growing Employee Provident Fund, plus your saving and investment in a safe manner, your total retirement sum can to a handsome RM4-5 million when you retire at age 60. At that time, due to inflation, the money you will have won’t be able to buy the same things you can buy today, but that RM4-5 million is still worth a sizable RM1.4 to RM1.8 million in today’s money, good enough for retirement for a reasonable lifestyle if by then you are debt free and commitment free.
Compound your saving at 10% a year is not from putting your money in the bank earning a meagre 3% interest, but by investing prudently in good businesses when they are selling cheap.
Also be mindful that earning a compounded annual rate of 10% will be unlikely to come from following tips, rumours and hypes in the stock market, or simply “tikam” any stock in the market. For if you do so which likely will result in losing big in the market, your dream of compounding your investment will be derailed for a long time, or even will never happen.
There ain’t tooth fairy and free lunch in the stock market. If there is, everybody who dabbles in the stock market would be rich, and there wouldn’t be this phenomenon of 90% of individual stock investor is losing money in the stock market as shown in many studies.
For those who are interested in your personal finance and the options and ways to invest for higher return than bank deposit in a safe manner, please contact me for a free eBook as a guide.
ckc13invest@gmail.com
KC Chong
https://klse.i3investor.com/blogs/kcchongnz/205498.jsp
