Compound interest: what it is and how to earn it
If there is one thing in the world that can make you richer (or poorer) this is compound interest. Those who earn it will never have to worry about having enough money. Whoever pays him will never get out of his debts.
But let’s go in order.
What is compound interest?
Compound interest is nothing more than the ability to generate interest on interest, a mechanism also known by the term “compound capitalization“.
But an example can clarify the ideas even more.
The simplest way to understand interest compounding is to think of grains of rice on a chessboard.
Legend has it that in 600 AD, an Indian emperor, enchanted by chess, decided to reward a farmer who had invented the game.
“Choose what you want,” the emperor said to the young peasant.
The farmer’s response shocked the king.
“I am a simple man with few desires. I would like to receive a grain of rice for the first square of the board, two for the second, four for the third, eight for the fourth, and so on…”
The rich emperor considered this request irrelevant and immediately ordered his treasurer to comply with the peasant’s wish.
It took the treasurer a full week just to calculate the amount of rice needed for the reward.
A grain of rice that doubles 64 times in a row (the squares of a chessboard) generates 9,223,372,036,854,780,000 grains of rice.
Eventually, he found that he could not honor his debt to the farmer.
The magic formula of compound interest
As you saw earlier, the magic of compound interest is based on exponential rather than linear growth (like that of simple interest).
To better understand this concept, suppose you receive a 3-week job offer. The company offers you to choose between two different salary conditions:
- You get paid $ 100 more every day than the previous day. So, $ 100 on the first day, $ 200 on the second, $ 300 on the third, and so on for 21 days.
- The first day you get paid 1 cent and the following days you double the previous day’s pay. So, 1 cent on the first day, 2 cents on the second, 4 cents on the third, and so on for 21 days.
Here is the development of the two options:
Compound interest in investments: how important is the time horizon?
None of us would like to be in the same situation as the Indian emperor, crushed by the burden of compound interest.
So, thinking about an investment is the first step to take advantage of the benefits of interest capitalization.
As we have seen, compound interest is based on an exponential function and the time horizon plays a key role in the investment result.
Warren Buffet is living proof that time is an investor’s best ally.
As can be seen from the image below, Warren Buffett’s growth in net wealth is reminiscent of the exponential function of compound interest.
The Oracle of Omaha began investing at the age of 14, but only in recent years has its assets grown dramatically.
Compound interest and how to earn it
We have seen the devastating force of compound interest in growing an asset over time. But how is it possible to earn it?
Investing in the financial markets is undoubtedly the natural habitat where you can build your wealth by exploiting the advantages of the capitalization of interests. And mutual funds can be considered one of the most interesting products to take this opportunity.
But money doesn’t fall out of the sky. Investing takes time and patience and the results take long time horizons.
For example, taking the last 70 years as a benchmark, the growth of investment in global equities was 7% per year.
However, the trend of investment is irregular: sometimes it goes up, sometimes it goes down, sometimes it stays still. You will never earn a set percentage each year, simply because the safe and guaranteed return does not exist.
In short, the recipe for achieving excellent investment results is simple: the more you wait, the more you get.
So, are you giving your investments time to benefit from the strength of capitalization?