Compound Interest Defined
Compound interest may be defined as, “the addition of an interest calculation to the principal component of a deposit or loan.”
In other words, it results in interest accruing on interest. In the personal investment sphere, it results from reinvesting interest, rather than paying it out. Hence, that interest in the next period is then earned on the principal sum plus the previously accumulated interest.
Care To Repeat That?
Compound interest is a commonly used term that describes the way interest is earned on an investment. It illustrates the repeating process of earning interest on the interest that results in the accelerated growth of an investment over time.
When you take out a loan and acquire a debt, however, compound interest works in a similar way but against you. You are liable for any interest accruing on your interest if you do not pay the loan off. This leads to your total debt growing exponentially!
Why Is Compound Interest Important?
This concept may seem obscure and a bit fiddly but it is not. Exponential growth can seem abstract and difficult to intuitively grasp. Hence, it is all too easy to ignore its powerful impact on growth or debt.
Take, for example, the option of having:
$2,000,000 cash today
You could receive 1 cent today and then double that every day for 30 days. So tomorrow you receive 2 cents, in 3 days you rece4 cents and so on.
Which option would you opt for?
If you chose option one, congratulations, you are now $2,000,000 richer. That’s better than winning the lottery! However, if you selected option 2, you would actually be $10,737,418 richer. Now that’s real wealth creation!
So, a big wad of lovely, lovely cash versus a seemingly trivial amount that just happens to double daily powered by the impact of compound interest. People it seems are not great and visualising the effects of exponential growth.
Compound interest is also a concept where the modern obsession with instant gratification results in our exiting many investment strategies way too early in a process, just because the initial growth trend doesn’t appear promising on the surface.
In the above example, at the end of the first fortnight, you would only have around $160. That doesn’t seem like much compared to $2,000,000! The process of compounding is initially quite slow and only accelerates later in the process.
The lessons of compound growth apply to our everyday investing strategy where investors typically target growth rates of between 9 and 10 percent annually.
Visualising Compound Interest
Compound interest is one area where the financial media have struggled to inform and communicate the benefits of the concept.
Take the example of a typical suburban investor. Grace earns a comfortable salary working in the healthcare sector. She is smart with her money and conservative and she prefers to live well within her means.
Grace lives in an average apartment, which she could easily afford to upgrade if she wished. Grace also drives a four-year-old compact car, takes her lunch to work every day and cooks her own meals.
After Grace pays her mortgage and her other monthly bills, she spends some money on personal care and socializing. After that Grace is able to scrape together $20,000 each year to invest. Grace diligently invests this every year into an ETF that returns about 9 percent annually on average.
As you would expect with such a conservative investment strategy, results accumulate very slowly initially. In the first 7 years of investing, Grace puts diligently sticks to her investment strategy despite the fact that it feels like she is treading water.
After the first seven years of investing, Grace only has accumulated around $200,000 most of which she contributed herself! Her investment portfolio appears to be growing in slow motion.
During years 1 to 7, Grace’s personal hard work and diligent saving are contributing most to the value of her investment portfolio and the organic growth has still yet to cut in and do much of the heavy lifting. However, from year 8 onwards, the organic growth does most of her investment’s heavy lifting for Grace.
In year 8 the pendulum shifts and the portfolio is actually growing organically in lockstep to the amount Grace herself is contributing annually.
A few more years into the future and Grace’s personal contributions are being outpaced by her portfolio’s organic growth.
So to benefit from compound interest, you need to persevere through the first few years before the full effect of compound growth kicks in and powers your investment.
Advocates of the financial independence and early retirement philosophy tend to value time ahead of cash.
The Power Of Time In Generating Investment Returns
Looking at Grace’s investment consider how long it would take for her portfolio to grow by $100,000 increments.
Using this basis, we can see it takes over four years for Grace to accumulate her first $100,000. However, with the benefit of compound interest, Grace accumulates over $900,000 in the final four years of her investment strategy! Each subsequent $100,000 increment is saved much faster than the previous, thanks to the accelerating influence of compound interest.
In a society where instant gratification is a key driver and market turbulence has undermined long-term investing as a credible strategy for achieving financial independence and enabling early retirement, compound interest is rarely discussed.
However, it has a part to play in any investment strategy. In many cases, time matters more than dollars, so consider evaluating your investment in terms of time rather than absolute dollars, particularly early in your investment!
Taking a general share market return of 9 to 10 percent, as a rough guide, an investor such as Grace can expect to be approximately 50 percent toward her goal measured in time when she is only 25 percent of the way to her goal in dollar terms. So once you have 25 percent of the dollars you need to generate your chosen passive income, you are in fact already “halfway there!” Time is always your best friend when it comes investment strategy. Hence, the best time to begin investing is right here, right now, regardless of how old you are or where your starting point.