There are many wonders of the world… seven official wonders… and many more unofficial ones. In the world of money, saving and investing, compound interest tends to fit the mould. Albert Einstein actually called it the 8th wonder of the world and the most powerful force in the universe. Stating that, ‘those who understand it, earn it and those who don't, will pay it.’ We know how it works—it’s just math. So why does it seem like such a wonder to many? Maybe because it seems too good to be true. Let’s un-wonder it.
Of all the things I remember from 5th grade, it was my math teacher’s impactful comment. She said to our class, ‘the thing I love about math is that it is either right or it is wrong.’ We can’t really argue that point and there is math behind just about everything in our lives. Compound interest falls into the holy grail of how investing and saving works—it just takes a while to see it in action.
Compound interest is the saving and investing process by which we grow our investment balance by, well, doing nothing. Quite possibly the only free lunch in the world of finance and money. To put this into actual math terms, we need to think about our own savings or investments.
Let’s say you invest $100 on January 1. Throughout the next twelve months, this money earns you 5%. What do you have in your account at the end of the 12 months? $105. Now you begin year two with $105. Again, you earn the same 5% over the next twelve months. You didn’t just earn $5 in interest, you earned $5.25. See where I am going here? It is simple math. Right math.
The bigger the numbers, the bigger the result. Use the same math above on one million dollars and you gain yourself $50,000 in year one. Year two gains you and $50,250. A $250 free lunch just by practicing a bit of patience. In the words of the late and great founder of Vanguard, Jack Bogle, ‘time is your friend; impulse is your enemy.’
The simple concept of compound interest is at the very heart of building wealth and saving for retirement. Some people can turn off the emotion that tells them that the more action they take, the more they benefit. They let math do its job. Others can’t seem to help themselves and disrupt a good thing. They get antsy. They think they can outsmart the math gods.
Compound interest can work the other way, too. Anyone who has ever carried a balance on a credit card and reviewed the billing statement knows what I am talking about (yes, I am talking to you). That $1,200 purse you just had to have or new Playstation you couldn’t live without didn’t only cost you $1,200. When the 18% APR (annual percentage rate) hits the balance, it hurts. When you don’t pay it and another month of 18% APR ‘compounds on top of it, you feel like the credit card company just took some of your soul. Compound interest can lift you up and it can also break you down.
Albert Einstein also knew that what benefits one side of the balance sheet can also disadvantage the other. Einstein quoted, ‘compound interest on debt was the banker’s greatest invention, to capture, and enslave a productive society.' There is no doubt that many in society have an appetite for debt and are in need of a diet. From credit cards to school loans, we could do a heck of a lot better as financial educators before mistakes are made. Ultimately, behavior is everything.
That said, our lives also utilize the process of compounding. We just can’t necessarily apply exact math to it, so we take the liberty of doing some emotional rounding. I could speak for hours on examples of this. We learn to play an instrument. The first week we learn one chord. The next we learn another, the next week we learn to use them both together. We are compounding. Don’t try to find a shortcut—you’ll likely not find one, but gain a bad habit instead.
Exercise is compounding. Learning as well. We didn’t become full-fledged adults in a day. We started as babies and compounded the knowledge of our brain and will continue until the end.
Courtesy, kindness and paying it forward compound freely— out of site and out of mind. An anonymous gift. Like many things, the behavior and mindset we take in life ends up trickling down to what we do with our money. And what we do with our money tickles down to the foundation of our future financial independence. We invest in ourselves; we invest in the market. We compound our knowledge and skills; we compound our hard-earned dollars. Why? Likely for the same thing. Advantage and independence. Just check the math.