Could compounding truly be the eighth Wonder of the World?
While most of us cannot access the seven wonders of the World in the immediate future, we can still access the eighth wonder of the world, compound interest. This is according to Albert Einstein, who said (allegedly) “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Imagine you’re out with your friends for lunch, and the queue for a delicious $10 meal looks rather long. Your friend might say “I am willing to stand in the queue to get the food, but you need to pay me 5% interest per minute until the food is ready.” You agree to these terms for a bit of fun, but the food takes almost 15 minutes to be ordered and made. Guess what? You just paid 200% the initial value of the item, and kindly bought your friend’s lunch. What a good friend you are!
But why did the interest cost so much in just 15 minutes? Compound interest is to blame (or thank from your friend’s perspective).
With compound interest, interest is calculated on the initial principle (i.e. the cost of the food) plus any previously accrued interest. So, after the first minute you’d pay 5% of $10 (50 cents) in interest, and then after the second minute you’d pay 52.5 cents, since the 5% rate is applied to the new total of $10.50. With each subsequent minute the amount of interest paid grows, and after just 15 minutes the original $10 debt will have doubled.
Like Albert says, those that understand compound interest earn it, and those that don’t, pay it. Compound interest works against you when you are paying it to others, usually in the form of debt, but when you are earning compound interest, like through a savings or investment account, the potential for growing your money begins to shine. Just like how interest can compound, so too can your investment returns.
While the food example is a bit of fun and jest, imagine the same situation with your hard-earned money. With markets often returning a long-term average of around 5% per annum, over a normal market cycle, one could expect to have double their initial funds after a period of fourteen to fifteen years.
However, markets can be unpredictable, and with past performance not being a reliable indicator of future performance, it’s not guaranteed that your investment would double after fifteen years.
Moneysmart has a great online tool which you can play around with to see just how much potential compound growth can have on increasing your savings.
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