It is now time that we take a good hard look at the most important concept of the whole monetary system: compound interest. Warren Buffett, one of the greatest investors of all time, credits compound interest as one of the three main reasons for his incredible financial success, saying, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” And Mr. Buffett’s longtime business partner, Charlie Munger, agrees with Buffett's appreciation of compound interest (no pun intended) by saying “Understanding both the power of compound interest and the difficulty of getting it, is the heart and soul of understanding a lot of things.” It is this writer's intent (and hope) that this post will explain compound interest in such a way that you will understand its unbelievable power, and subsequently make sure that this super power is working for you rather than against you.
So what is compound interest? It is the interest added to the original amount invested, as well as the accrued interest on that amount. Or rather, one could think of compound interest as a snowball, that as it rolls down the hill it picks up more snow; only in this case, the snow is money and the hill is time itself. In other words, it takes time for the money to accumulate but as it does it picks up momentum and accumulates faster. You see, the pattern is the same: gravity causes the snowball to pick up snow faster and get larger as it rolls down the hill, and likewise compound interest causes your investment to pick up more money and get larger over time. I will show you exactly what I mean with the following spreadsheet.
This spreadsheet depicts a very basic 10 percent annual return on a one-time investment of $1000. According to Investopedia, the stock market has returned an average of about ten percent annually over the past 90 years. So one can see that this is a very practical chart for understanding the reality of investing and the power of compound interest. As the spreadsheet makes clear, the numbers increase very slowly at first, but over time once the snowball starts gaining speed, the numbers become very large very quick. After year twenty-five, the yearly return is even larger than the original $1000 you put in in the beginning, just a quarter century earlier. I know what many of you are thinking, twenty-five years is way too long to wait for my money to multiply only by10. Well, that's one way to think of it. However I like to think instead that the money increased 1000 percent (which is also true) in just two and a half decades. It's all in how you look at it. And furthermore, if waiting for the compound interest to gain momentum is still a problem for you, then I am at a loss, because it's like the old adage goes: time is money. For you see, time is a very important component of compound interest, and by extension of money itself. You are just going to have to accept that fact. Most superpowers have some kind of inherent weakness. Superman was susceptible to kryptonite, and compound interest's inherent weakness is impatience. You must give compound interest the appropriate time to build on itself for it to truly display its supernatural ability. Currently, Warren Buffett is one of the richest men on the planet at just shy of 90 Billion dollars at the time of this writing. It’s important to note that he had not made a billion dollars in his lifetime until he was over 50 years old. Mr. Buffett made his first investment at the age of 11, and he knew that if he just invested wisely and waited patiently, the compound interest would work its magic and he would become incredibly rich. Nonetheless, not everyone uses compound interest to his or her advantage.
I imagine that when I was explaining the aforementioned snowball analogy, some of you were picturing yourself behind the snowball, rolling the snow down the hill. That image illustrates how compound interest can work for you -- if you are making the right money moves and investing correctly. However, compound interest can also work against you. I want you to picture yourself at the bottom of the hill now, and imagine the snowball rolling down the hill towards you, and as it picks up more snow along the way it becomes an avalanche bearing down on you, about to consume and suffocate you. This is how compound interest can work against you – if you have credit card debt, student loan debt, auto loans, etc. The same way that the right investment can make you wealthy over time (by building upon its own gains), so too can taking on more and more debt with higher and higher interest rates strip away all of your money over time and cripple your financial outlook.
The purpose of this post is to show you something I find very interesting (pun intended), so that you might better understand the most important component of the whole monetary system: money's super power: compound interest.