Compound Interest
Albert Einstein once said that “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.
So, it must be pretty good right?
And it absolutely is. That’s exactly why you keep hearing about it.
Compound interest is the idea that you put the money you earn to work by investing it and it starts to earn you extra money. You then also put the extra money to work, and it earns you even more money. And on it goes.
Another way to think of it; imagine you're on the top of a snow-capped mountain. You pick up a fresh piece of powder and work to shape it into this perfect snowball.
Then, you ask it to grow by itself. You put the snowball to work and send it down the mountain.
It picks up more snow as it rolls along. It gets bigger and bigger. It gathers more and more momentum. As it gets bigger, it picks up more and more snow. Now it’s getting bigger, quicker. It’s snowballing.
Imagine if that snowball was your money!
One of the problems we have with understanding compound interest is that our brains don’t think about exponential returns very intuitively. We’re much more comfortable with thinking about things in a linear manner.
To help demonstrate this, answer this question:
1. You have the option of taking $1 million now or 1 cent that doubles every day for 30 days. Which would you choose?
If you took the 1 cent, you would end up with $5,368,709.12.
In hindsight, it’s now obvious what you would choose, but at first glance you would’ve had some temptation to take the one million and run.
This also highlights another difficulty with compound interest; the fruits of it take some time to realise.
Time is our biggest asset when it comes to compounding. We must be patient and as Charlie Mugger says, “the first rule of compounding: never interrupt it unnecessarily”.
But one of our most prevalent biases, the present bias, actively tries to sabotage our efforts.
The present bias says that we tend to overvalue immediate rewards as opposed to rewards in the future, even if there ward in the future is much larger. Netflix, online shopping and many other of the “on demand” services are a testament to this.
Financial planning and having a solid cash flow management structure in place can help limit the impact of the present bias and allow compounding interest to win the day.
As a part of your financial plan, you should have a “financial defense” component that provides you with a solid foundation that allows you to maximise the powers of compounding interest.
A great financial defense could include:
1. Keep an emergency account – the benefit of having instant access to funds at short notice cannot be underestimated. Not only does it mean in the event of a financial emergency that you’re less likely to be selling down investments that are meant to be compounding, but it can also provide you with that sleep at night factor.
2. Create a high savings rate – by having a high-savings rate, it means that we can consistently add to our investments, increasing the power of compound over time.
3. Personal insurances – you are your biggest asset. By protecting this, it can help ensure that even in the event of a medical or health catastrophe, the emotional stress is not compounded by any financial stress. Yes – compounding can work in the opposite direction too!
Wishing you the best of luck on your path to financial freedom!
