#5 Compound Interest, the Most Powerful Force in the Universe đȘđŒđ
The butterfly that caused a storm on the other side of the world
To Infinity and Beyond
You might have heard that compound interest is the strongest force in the universe. It is attributed to Einstein, although itâs not proven to be something that he said. More likely to have been somebody in the pre-Twitter age who wanted to lend credibility to their idea.
Anyway, this doesnât detract from the fact that compound interest is an incredibly powerful tool when it comes to building wealth. And thatâs why weâre here right? To figure out what steps we can take to build sustainable wealth.
Compound interest is actually perfectly logical. The problem is that we have little grasp of exponential growth. Our brains function much better when we look at linear growth. Thatâs why we struggle to comprehend that folding a piece of paper in half 42 times will reach further than the MoonâŠ
The first time I saw that, I struggled to believe it. âHow could that possibly be true?â I thought. But then I started to look behind the curtain and understand exponential growth more.
You see, the crazy thing about exponential growth, is that if you keep repeating an action, no matter how small that action is, it creates such momentum that the end result is far beyond anything you could have imagined.
Letâs take a look at this from an investing perspective đđŒ
This is a simple calculation that shows the effect of compound interest. (The graph is in USD but luckily the rule applies in all currencies đ)
In investing, this effect is achieved through dividends, which are payments made by companies as a thank you for holding their stock. You can (and should) reinvest these dividends back into the market. This is the âinterestâ where shares are concerned.
The interest you earn is added to your contributions. The year after that, interest is a percentage of your contributions plus last yearâs interest. You earn interest on the interest. The year after, same again. You earn interest on the interest on the interest.
And so on, and so forth.
As time passes, the effect becomes impossible to ignore. The graph shows monthly contributions of ÂŁ100 and a yearly return of 10%, which is the average annual return on the US stock market over the last 30 years. It shows that, despite the fact that youâve only put in ÂŁ30k of your own money, your account shows ÂŁ118k. The rest is from compound interest.
The interest you receive earns interest. Itâs a snowball effect.
The best thing is that it will only continue to grow faster and faster, while you keep putting the same amount in every month.
As Benjamin Franklin once said âMoney makes money. And the money that makes money makes more moneyâ. From an investment point of view, this could be considered the Holy Grail!
Now, letâs assume that instead of for 25 years, you invest for 35 years. You might think you maybe have a third more money, perhaps about ÂŁ160k-ÂŁ170k.
Luckily for us, youâd be wrong.
The actual answer is ÂŁ325k.
Now the avalanche is really moving at speed, and the dividends you receive each year are far beyond that of your own contributions of ÂŁ100 per month.
Letâs go crazy and say you leave the money investing for 45 years, from when youâre 20 to when you retire at 65 (if thatâs still even possible when we get to that age!)
Imagine that it increased to ÂŁ500k! After all, itâs only another 10 yearsâŠ
However, this is when the investment pot is growing fastest. It grows by more and more each year. The avalanche is most powerful as it nears the bottom of the hill.
After 45 years, instead of ÂŁ500k, youâd actually be more likely to have ÂŁ860k!
And exactly how much of that is money youâve contributed?
ÂŁ54,000.
Iâm going to leave a space to let that sink inâŠ
When effectively employed and managed, nothing will work harder for you than your own money.
And if, heaven forbid, you continued investing ÂŁ100 per month for just 2 more years?
Your portfolio would grow another ÂŁ200k and put you squarely in millionaire territory.
All off the back of ÂŁ100 a month.
The key takeaway from all of this is that if youâre not investing, youâre missing out on the greatest wealth building tool there is.
And although you would have much better returns if you had started 10 years ago, you literally cannot afford to waste any more time in starting.
The longer you can let it run, the more massive the results will be.
You see, the thing about compound interest is that, at the beginning, the effects are negligible.
Theyâre not exciting, and they donât impress that person youâre chatting up at the bar.
But just as you didnât like wine or coffee the first time you tried it, give it some time.
I can assure you; the results will be pleasantly surprising.
Just a quick note before I disappear! đđŒ
I create these newsletters to talk about subjects I find interesting, and I think that we would all benefit from learning more about.
However, what Iâd love even more than likes, comments and new subscribers is to hear your feedback.
Seriously, nothing would make me happier than to know what you liked, what you didnât like, what topics youâd like to see in the next one. Feel free to drop me a line at hello@stoicwealth.co.uk or send me a message here, and Iâll be sure to get back to you.
Or if youâre happy just as it is, hit the like button so I know Iâm not barking up the wrong treeâŠ
See you all in the next one!
Felix