Albert Einstein is credited with having said that “Compound interest is the 8th wonder of the world.”
When I hear something like that, it tends to pique my interest.
After all, if Mr. Einstein himself is thinking so highly of it, there must be SOMETHING good about it.
When Warren Buffett was a young boy, around the age of 7, he learned about the concept of compounded interest. Among many others, he had taken out a book from the library called “1,000 ways to make $1,000.”
As the title might imply, the book contained many ideas and strategies around earning money and building wealth.
One of the concepts was compound interest.
Warren became fascinated with this concept, and it pushed him to work harder and earn more money, so he could invest that money and grow it even more.
It has been one of the driving tenants that has pushed Warren throughout his entire career. In fact, it was something that he was so enamored with, it caused a rift between he and his first wife.
She was a huge advocate of the needy, and was constantly pushing Warren to give away more of their wealth.
It wasn’t that Warren didn’t want to do good. He just recognized the power of building upon what you already had, and he was looking to the future. He saw that if he continued to let the power of compound interest work, they would amass a much greater fortune in the years to come. And this fortune could be used to do even more good.
It was a battle between doing good now, and doing even more good later.
But that’s another story…
COMPOUND INTEREST EXPLAINED
So, what is compound interest?
In essence, it’s the idea that your money can build upon itself. It’s the concept that you can invest money and earn a return, and then continue to earn returns on top of your original money AND the returns you previously earned.
If you invest $100 and earn a 10% return, you will now have $110 – a $10 profit!
But now, if you invest the entire $110 and earn another 10% return, you’ll end up with $121 – a $11 profit.
The magic of compound interest is that additional $1 dollar you received by investing the increased quantity of money you have. It’s the interest you earn on top of the previous interest you earned.
At first, the incremental increase in returns is seemingly small. But over time, the returns build and build, until the dollar amounts you are receiving are gigantic.
That is what Warren realized. Once he had grown his wealth into the millions, and then billions, a 10% return meant an incredible sum of money.
Let’s repeat the same example from above, but with larger numbers.
If you invest $100 million and earn a 10% return, you will now have $110 million – a $10 million profit.
If you reinvest all of that $110 million and earn a 10% return, you’ll now have $121 million.
Now, that $1 of incremental gain has turned into an additional $1 million!
PATIENCE & THE RULE OF 72
The real key to benefiting from compound interest is to invest early and often, and to let the magic run its course.
It will take some time, but eventually, you begin to see real growth in the numbers.
But if you are antsy, there is a neat trick to figure out how your might grow called the Rule of 72.
The Rule of 72 states that given a fixed rate of return, you can figure out how fast you will double your investment by dividing the number 72 by the rate of return.
If you expect to receive 10% return each year, you divide 72 by 10, and you discover that it will take you approximately 7.2 years to double your money.
TYING IT ALL TOGETHER
The concept of compound interest is one that has allowed many people to build vast fortunes throughout their lives.
There are 3 main problems that stop most people from building wealth:
- They don’t save enough
- They don’t invest enough
- They don’t have patience
Will you be different?