The story I am about to share with you showcases the beauty of the 8th wonder of the world – compound interest. In essence, compound interest is earning interest on interest. It is an all important concept to investing and it is necessary for every investor to understand its effects if he/she desires to be a successful investor.
The famous legend goes like this. When the inventor of chess showed the game to the Indian king, the king was so enthralled by the new tactical game that he told the man to name his reward.
The man responded, “Oh king, 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 for the third square, eight for the fourth square and so on for all 64 squares. With each square having double of the grains of rice of the square before.”
Amazed at that the inventor had asked for such a small reward, the king happily agreed to his request.
However, after a week, the king had to give away his kingdom because he was unable to fulfil his promise to the inventor. On the sixty fourth square, the king would have to put 18,000,000,000,000,000,000 grains of rice, which is enough to cover the whole of India with a meter thick layer of rice!
For some reason, compound interest is a concept that is challenging to wrap our heads around. This is why one of the greatest scientist, Albert Einstein said “Compound interest is the 8th wonder of the world”. Thus, I encourage everyone to pull out an excel sheet and do the calculations to see the compounding effect for yourselves.
Of course, in reality our investments don’t double every year. Regardless, the same principal of compound interest holds true. Suppose that Tom has an annual income of $50,000 and invests 10% of his income ($5,000) a year in an ETF that returns an average of 8% annually (This is a reasonable benchmark).
In the first year, the returns would be a measly $400. That would be good to buy a nice set of headphones but you can’t retire off such a small return.
After 5 years, Tom’s portfolio is now worth $30,000. This provides a return of slightly more than $2,300. The idea of investing is making your money work for you. Yet, Tom feels like he is working harder than his money. However, always remember that these are only the first few squares of the chessboard and that the investments has only just begun compounding.
By the 10th year, Tom’s investment will grow to $72,000, returning more than $5,000. This is more than his annual contribution and you can begin to see his money working for him.
Another 5 years later, his portfolio’s annual return will be $10,000. Double that of his annual contributions. By the 25th year, Tom’s portfolio will return almost $30,000 annually. That is 6 times his annual contributions. You can now visualise how as time goes by, his portfolio starts working harder and harder for him.
If Tom begins investing at 20 and retires at 60 his investments would snowball to $1,295,000. This will yield him $100,000 annually, double his annual income of $50,000! Tom can now retire comfortably and happily with his family 🙂
Additionally, implied in the above example is that compounding takes time to ramp up. Let us see what happens if Tom only begins investing 10 years later at 30 years old and retires at the same age of 60. He will now have an investing period of 30 years. Based on the excel sheet calculation, his investments will amount to only $566,000 (the row highlighted in green). He will enjoy a mere annual return of slightly more than $45,000, meaning that he would thus be unable to retire as comfortably. This goes to show how big a difference time can make, simply by starting 10 years earlier will allow you to retire with more than double the amount of money!
Thus, it is important to start investing as early as possible, no matter how small the contribution. Remember, the earlier you invest, the more time your investment will have to compound and the more money you will make. To learn how to begin investing with a small sum of money, check out my other post here.
Below is an illustration of how the S&P500 index looks like when you zoom out. You can see that it takes the shape of an exponential curve! This is the marvel of compound interest.
To end this, I would like to sum up 3 takeaways I hope everyone has learnt from this post:
- Don’t take out the returns to buy the latest iPhone or PC, leave the money in there to take advantage of compound interest. Reinvest dividend pay outs as well to maximise the compounding effect.
- Compounding takes time, so start early, stay the course and let compound interest do the work.
- It does not matter how small your contribution is. Although the returns might seem measly at the start, it will ramp up as time goes by due to compound interest.