Compound Interest: Taking Einstein For Granted by J. J. Wenrich CFP The Startup

Let’s say you have $1,000 in a savings account that earns 5% in annual interest. In year one, you’d earn $50, giving you a new balance of $1,050. In addition, you’re going to have a MASSIVE opportunity cost. On average, the stock market goes up 10% each year as I have mentioned but I like to use that 8% number just to be safe.

  • After all, he’s famous for making complicated things easy to understand.
  • Now, just for fun, imagine in the above example that each period represented a year instead of a day.
  • Still, to us finance types, compound interest is still pretty darn powerful and noteworthy.
  • Nowadays it’s somewhat hard to go out to eat for under $10, and then you can tack on a 20% tip and end up at $12 pretty quickly.
  • Einstein didn’t just say that it was pretty cool or good in some way; he said it was the most powerful force.
  • That’s a $27,000 gain — not a negligible sum, but not nearly as impressive as a gain of $155,000.

For each row, the number periods and the interest rate in each period are shown (20%/n), followed by the total at the end of one year and the delta from the simple yearly compounding. That’s why you must employ a system like Dollar Cost Averaging. When you decide to put the same amount of money into the market every month, you automatically buy less when the market is up and buy more when it’s down.

Forget Me, Let Albert Einstein Explain Compound Interest and How You Can Master It!

Well, while you’re paying off this debt you’re missing out on extremely valuable time investing in the market. Before we get too far into the weeds, let me first explain what compound interest is. The concept is that when you earn interest in X amount of time, that next time period you’re going to earn interest on the principal AND the interest that you previously earned. Basically you’re double dipping on return on your investments.

Having a longer investment horizon is important as the effect of compound interest may not be obvious in the short term, but will be realised over time. While young people may not have much money to invest with, time is on their side and they are in the best position to take advantage of compound interest to accumulate wealth. The above example of doubling a dollar a day may sound unrealistic. However, in the real world, many do expect to have their investment returns double within a short period of time But the fact remains, the higher the potential returns, the higher the risks. Simply put, the more returns you seek, the higher the chance of losing money. Albert Einstein once said “Compound interest is the eighth wonder of the world.

But what if we saved just a little bit for them. The market is massive, facilitating trillions of dollars a second into and out of securities, futures, and commodities. Your guess at what it’s going to do next is as good as the next guy’s. Until you find someone that can predict the future, you’re just going to have to face the fact that you won’t be able to time the market. It’s so effective because not only does it teach you discipline and good habits, but it prevents you from making stupid mistakes in the stock market. The words compounding interest are two of the most powerful in the investing world.

Einstein’s Compound Interest Quote Explained

You might, instead, consider that the ‘average’ exam paper is the one that has the score that most people achieve. (The ‘average’ response to a question could be interpreted as the answer that the most people people think). The mathematical word for ‘average’ is the word ‘mean’, but there are many different kinds of mean depending on what you are trying to measure! If you were grading exam papers, you might want to calculate the arithmetic mean. This is typically what most people think of when they talk about the ‘average’.

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” At the end of the day, compound interest is always going to make a lot of money for someone – just do your best to make sure you’re the someone that it’s making money for. If you want to go out and buy something fancy on a credit card, that’s fine – but pay that thing off.

The so called “snowball effect” shows that small actions continued over the long term can have large impacts. Quote investigator also found some earlier quotes claiming that compound interest is the “greatest invention”, but none of them involve Einstein in any way until well after his death. When asked to name the greatest invention in human history, Albert Einstein simply how to raise funds for a new nonprofit replied “compound interest.” In conclusion, this article presents a snapshot of current research. The label “eight wonder” was applied to compound interest in an advertisement for a bank in 1925. No attribution was provided, and anonymous advertising copy writers have applied the “eight wonder” label to a wide variety of objects and ideas for more than two hundred years.

Student loans, mortgages and other personal loans. Compound interest works against you when you borrow. When you borrow money, you accrue interest on any money you don’t pay back. If you don’t pay the interest charges within the period stated in your loan, they’re “capitalized,” or added to your initial loan balance.

You’re Wasting Your Time Trying to Build an Audience

In the graph below, the blue line shows the cumulative compounded interest, and the orange dotted line shows the curve of constant 12.1% interest. By definition, the two curves meet at the beginning and end of the period. To calculate the geometric mean, we multiply all n individual percentages together, then take the nth root of this product. By multiplying all the percentages together we get the final compounded value, then, by taking the applicable root of this value we distribute this appropriately over the periods ‘equally’.

More from J. J. Wenrich CFP and The Startup

Finally, converting R from a decimal into an, easier to use, percentage requires multiplying by 100. Our estimate shows that it should be 69.31/percentage rate, so why is 72 used? The simple answer is that 72 has many factors (1,2,3,4,6,8,9,12 …), and since it is meant to be a rule of thumb calculation, using 72 makes it very easy to get quick approximations. This geometric mean reduces the series of individual interests into one ‘average’ fixed number that we can simply use in the simple fixed-rate compounding formula.

Well, for one, you don’t see results overnight. In fact, compounding interest is actually pretty boring, it can be like watching paint dry. Just as a snowball compounds and grows, so can your wealth.

Once you understand what compound interest means, it can change your perspective on money and investing. This can be done quite simply by opening a brokerage account, picking a S&P 500 ETF like SPY and then investing that money. It’s very simple – legit a 15 minute process. Warren Buffet, CEO of Berkshire Hathaway, one of the biggest investment firms in the world has used compound interest to his advantage. He has said that “time is your friend”, and advised investors to “take advantage of compound interest”. Here is a plot of the outputs of these investments against time.

Simply divide 72 by the interest rate, and voila, you have the number of years it’ll take to double your money. After a year, if you don’t pay anything back, you’ll owe $180 in interest, making your total debt $1180. Now, what if this interest starts to earn its own extra money? Thus, taking the compounding effect into account, the real amount of interest paid during a year is higher than only considering the nominal interest. Thus, at the end of 10 years, you will have to repay a total of R8,235.05 (the principal of R5,000 plus the interest of R3,235.05). FYI – Robbins’ exact line was “Compound interest is such a powerful tool that Albert Einstein once called it the most important invention in all of human history.”

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