Compound Interest | World’s Most Powerful Force
Welcome back! Just a quick note: I am not a financial advisor or in any way qualified to provide financial advice. I am just some guy on the internet with a blog, where I share my experiences and thoughts. You should do your own research and seek advice of a qualified professional.
Now, let’s discuss compound interest!
It was my senior year in high school. I was planning on attending the University of Washington to study physics. I thought I knew my path in the short term (academically) but I was still exploring different career paths. Let’s go back in time for a little bit.
Career Day (2004)
My senior class is participating in career day. It is an opportunity to hear professionals describe and answer questions about their careers and potentially inspire us to pursue those career paths. I am reading the list of different presentations searching for a speaker/career that match my interests.
I am still exploring the following career ideas:
eventually join the military and pursue becoming a medic/doctor, or
study physics and/or neurobiology to become a researcher/professor and/or physics teacher, or
become a police officer.
Unfortunately, there is nobody on the list that appeals to my potential career interests.
Therefore, I decide to randomly land my finger on the page to choose the presentations I would attend.
For one of the presentations, my finger lands on a session by an investment advisor or some sort of financial planner.
“Eh, it might be interesting,” I tell myself.
I am in the classroom and I am doing my best to listen to the presenter. It all seems too far away into the future and irrelevant to me right now. All the money I am making is going to expenses and saving for college and soon I will have even more expenses (and definitely no spare money for investing). Besides, I am not an investor (don’t I need a suit for that and live on Wall St?). And I will not be one anytime soon as I will be working multiple jobs to pay my expenses and besides, investing is something wealthy people do. (Exactly 18 year-old self! That is why they are wealthy).
Back to the story.
The man presenting catches my attention when he explains that the greatest wealth building tool is the use of compound interest. I was a mathlete and therefore this intrigues me. He shows a graph separating the principle investment from the gains from compound interest. And also the difference of the growth between simple interest and compound interest. (Reference the graph I drew of compound interest versus simple interest. Notice I have Einstein next to it so you know it is very scientific).
Oh! Wow. That’s cool. (I think only briefly as I look at the sheet for the next classroom I need to go to for the next session).
I briefly think how mathematicians derived “e,” which took me down an interesting path exploring approximations, such as logarithmic functions and, of course, calculus which I was currently taking.
Am I in math class?
I thought this was about finance, no this all makes a lot of sense. It can’t be math.
Okay, whatever! I wonder what’s for lunch?
Today (2021)
Alright, let’s travel back… err well, forward in time (spacetime!).
Like compound interest, an initial investment in our understanding may seem, at first, insignificant. However, given enough time it can grow into a surprisingly large return on investment. Knowledge is valuable!
Today, I wish I knew the name of that man so that I could thank him. Unfortunately, I had not realized on that day how much of what that man said would stick with me over the years. The ideas continued to rattle around in my noggin and still do today. I wonder why I studied calculus in high school, but not personal finance.
That presentation was the most important financial lesson anyone taught me in high school. Connecting what I had learned in math class with what I should have learned about finances impacted my financial future more than any other single event.
The Simple Math
A popular formula is used for approximating the doubling of an investment at a specific and fixed annual interest rate. It is known as the Rule of 72.
For example, if we want to know how many years it would take $100,000 to double (without any further contribution), we could approximate by assuming a likely fixed interest rate. Let us assume a fixed interest rate of 9% for simplicity. To apply the formula, we would take 72 and divide by the interest rate (9), which equals 8 (number of years to double the initial value of the investment).
So let’s think about this briefly.
Simple interest would produce $9,000 each year for a total $72,000 after 8 years for a grand total of $172,000.
(9% of 100,000 is $9,000 | $9,000 x 8 years = $72,000)
But with compound interest, the money earned from interest is now also making interest.
In 8 years, that interest on interest accounts for approximately an additional $28,000.
(For those of you doing the math, I know I’m slightly off - it would be an additional $27,256.26).
Still the difference is $172,000 (simple interest) versus $199,256.26 (compound interest).
This is the power of compound interest versus simple interest! And the more time is involved, the more powerful the compound interest becomes. Think of its power as a function of time. More time equals more power to grow your investment.
To prove this to ourselves, let’s look at this same scenario after 30 years instead of the approximate 8 years it would take to double our initial $100,000 investment.
After 30 years, your initial investment of $100,000 dollars has increased to (again, without adding any more money to it)…
are you ready for this?
You sure… sit down if you are standing. #safetyfirst
Stop walking if you’re reading this on the go… I don’t want you to embarrassingly walk into a street light. #ihaveneverdonethat
Your investment is now worth $1,326,767.85.
That’s right - you’re a millionaire (and then some). Your money worked for you. It made you over a million dollars. Your $100,000 made you $1,226,767.85.
Carrying a balance on credit cards with high interest rates is burning-up your money and cash flow (okay, maybe not literally, but you get the picture).
What’s the point?
If you read my last post, New Year’s Revolution | Just Be Resolute, then hopefully you remember that each household with a credit card holds on average over $8,000 in debt.
I have spent so many hours listening to Dave Ramsey that he is essentially Uncle Dave to me (no actual family relationship, sadly). Uncle Dave is king in this space and if you have struggled getting out of debt, then you should seriously consider listening to him and reading his books.
Anyways, I want to connect the idea of money working for you with the last post as we continue the financial independence series of posts. Is your money working for you or for someone else? Is your money working for credit card companies? If so, your money is likely working for them at a much higher interest rate than 9% we used for our example earlier.
Let’s consider what we learned about compound interest as a tool for wealth building. Money is fairly simple when thought about in this way:
We can SPEND money (includes giving and charitable spending)
We can SAVE money
We can INVEST money
We sometimes confuse saving money with investing. We are often told that the wise save money for their future. That we must “save for retirement!” To make things clear and simple - saving money is NOT investing money.
Investing money means we are doing something with that money that will likely produce interest, dividends, asset appreciation, or some sort of income (like rental income).
Now, this may start to sound a bit more complex. But don’t worry if it does. We will explore all these in the future and keep things simple and at times dive deeper in areas that you, the reader, requests and if I think I can confidently and comfortably provide some value.
Now, let’s get back to investing. Investing is when we put our money in an asset that will likely (based on research and due diligence) make us more money.
If we want to be resolute about achieving our financial goals, we may need to explore the reasons for making sacrifices and face our fears that often drive our counterproductive financial behavior. We must have self-knowledge and a more clear understanding of how money works so that we can be admirably purposeful with it.
Questions to think about as we continue building the foundation of knowledge around personal finance is:
How do I use money? (Remember: spending, saving, investing)
Is the way I use money consistent with my purpose and goals?
What is keeping me from pursuing what is meaningful and brings purpose to my life? (This question often reveals to people that money is simply a tool rather than the goal that people pursue).
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I plan on writing a series on financial independence, among other off-duty wellness topics. I invite you to leave a comment or contact me and let me know if you have any questions, suggestions, or feedback (so that I can learn to better serve you). Following the social media channels (see below) will allow you to stay updated on blog posts being released and any news from Boukabou Solutions.
