For more on compound interest and personal finance, check out Tony Robbins’ book, MONEY Master the Game: 7 Simple Steps to Financial Freedom.
Compounding is when an asset’s earnings from either capital gains or interest are reinvested to generate additional returns. Compound interest is the interest you earn on interest. In other words, it’s what happens when you reinvest all profits with the principle as it continues to multiply with continuous reinvesting.
Compound interest is so powerful that Albert Einstein is said to have called it “the most powerful force in the universe.” It is the true meaning of “passive income” and “let your money work for you.”
A Huffington Post story talked about a woman celebrating her 98th year as a local bank customer. June Greg‘s father deposited $6.11 into her account 98 years ago, when she was only two years old. Neither the article nor the bank said how much the $6.11 would have grown to today. But if the account were a high-yield savings account and paid a 2% interest rate, June would now have $42.55. If the interest rate were 6%, she would have $1,845.08. But what if she had a 20% interest rate? That measly $6.11 would have compounded to $351,401,266.90!
After understanding how powerful compounding is on augmentation, it’s clear to see how Warren Buffet became so wealthy. His company, Berkshire Hathaway, has posted average annual returns of 17.1% since 1985.
Another example is from a man dubbed the richest man in the world—Andrew Carnegie. During his lifetime, Andrew Carnegie became one of the wealthiest men on the planet. Before he began giving away his wealth, he had a net worth valued at $480 million (the equivalent of about $309 billion in today’s dollars). Carnegie is one of the catalysts for philanthropy as we know it today. He pioneered the movement and made it fashionable for the ultra-rich to give away most of their wealth.
Carnegie was passionate for American educators and strongly believed in education. He wanted to help provide professors at schools like Harvard, Princeton, Yale, Stanford, and Columbia with financial security in their old age. So in 1905, he gave $10 million to set up America’s very first company to sell annuities and low-cost life insurance to support college professors. Carnegie’s annuity company started with $10 million, and with the magical help of compound interest, it is worth a stunning $866 billion today. It is now called the Teacher’s Insurance and Annuity Association.
I mean, just look at the graph above. Both situations start with the same exact amount at P, but the simple interest earns the same (+x) amount recurrently, resulting in linear growth. Meanwhile, the compounded amount has an ever-increasing gradient which continuously gets steeper as it is multiplied.
Thinking of this from a logical perspective, wouldn’t you prefer to multiply your money every year rather than add to it yearly? Given an infinite amount of time, the compounded growth will ALWAYS amount to more than the simple interest no matter how big the head-start or how large the gradient is on the simple interest.
Another great way to illustrate this point is a quote from Tony Robbins that gives an example of an 18-year-old who would invest $300 a month for eight years then leaves it alone until retirement:
“Take someone who invests eight years till he’s 27 and invests a total of $28,800, or $300 a month, and then just leaves it there—doesn’t add another penny. He’ll have nearly 2 million when he retires at 65 if the market continues to compound like it has (at 10% or more annually on average).”
This same example also shows us how valuable time is to compounding, let’s look at another situation explained by Tony “If his buddy doesn’t start till he’s 28 and he invests $300 a month, he’ll have invested $140,000 by the time he retires at 65. But his compounding returns will end up at almost $300,000 less than his friend”.
The simplest way to start investing with low risk is to contribute to your employer’s 401(k) plan, a tax-advantaged retirement savings account, or other retirement savings accounts, such as a Roth IRA or traditional IRA.
Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it.”Albert Einstein
Remember June Greg from earlier? Fun fact, if June’s $6.11 would have doubled every year for the 98 years, she would probably have enough money to buy a few planets… or galaxies… Who knows what that costs. She would have whatever number that is below.
(Apparently, Americans call that number nonillion, and other parts of the world call it quintillion)
Do you think compound interest is the most powerful force in the World?