Why Compound Interest Is Your Most Powerful Financial Tool

There’s an often-told story that when Albert Einstein was asked what mankind's greatest invention was, he replied, "Compound interest." There's even one claim that Einstein called compound interest the "8th Wonder of the World."

While there’s some debate on whether Einstein really said any of this, there’s no doubt that compounding interest is an amazing financial tool.

As one Wall Street Journal article emphasized, compound interest is the “great equalizer.” Whether you’re a low-paid cashier or a highly successful investment banker, almost anyone can build great wealth with time and consistent investing.

What is Compound Interest Anyway?                           

Quite simply, compound interest is interest earned over time that gets added to the principal. Because interest builds on interest on the actual money you put aside, it grows at an exponential rate. 

What else grows exponentially? Human populations. Invasive plants. Pandemics. Fires. The mold in my refrigerator. Among these options, I’ll take the compound interest!

Despite several examples of exponential growth in our world, it’s been proven that the human brain has a hard time comprehending what it is and how it works. Which is why several smart people have tried to come up with different ways of teaching compound interest. Here are a few of those examples.

Ben Franklin and His Gifts to Boston and Philadelphia

When Ben Franklin passed away in 1790, he left behind a small gift of $4,000 each to the cities of Philadelphia and Boston. But using his gift came with a caveat: The cities must leave most of the donation invested for 100 years. After that time, 75% could be spent on public works and loans for tradesmen. In addition, the remainder must be invested for an additional century.

After the first 100 years, a portion of Franklin’s gift was used to fund a museum, a library, and thousands of scholarships for apprentices and medical students.

At the end of the 200-year period, the two cities combined still had $6.5 million to spend as they wished. Franklin’s experiment taught an important lesson about how money grows over time.

The Snowball Approach by Charlie Munger

Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, has likened compound interest to a snowball rolling down a hill. Munger teaches investors to roll a well-packed financial snowball (in his opinion about $100,000) down the longest hill you can find and watch it grow!

In the beginning, the initial lump of “snow” (the principal) may seem small. Adding layer upon layer of additional snow (interest) on top of the lump, however, quickly amasses into a huge ball worthy of becoming the base of a large snowman (your nest egg).

“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things,” says Munger.

Math Lessons on the Golf Course with Tony Robbins

Tony Robbins, master communicator and author of MONEY Master the Game: 7 Simple Steps to Financial Freedom, is known to take people out on the golf course to teach them about compound interest. Here’s how he does it:

Robbins begins by suggesting to his golf buddies that they make the game more interesting by betting a dime a hole.

Since $0.10 multiplied by 18 holes is only $1.80, Robbins’ golfing buddies are usually quick to agree. 

Then, Robbins takes it to the next level. “I have an even better idea,” he says. “How about we start with $0.10 to the winner on the first hole, but then we double the award at each hole?”

A long pause. Most golfers do some quick math, maybe noting that by the 5th hole they’ll have to come up with about $2, and they nod their heads again.

Often it’s not until Robbins beats them on hole 15, and they’re each paying $1,600 to the winner, that the weaker golfers start to realize how badly they’ve been had. By the 18th hole, the winner receives a little over $13,000 from each golfing buddy.

For any doubters, here’s the math:

With this powerful example, Robbins teaches the power of compounding and how it can help you double your money. If you’re a good golfer, you might try this next time you’re out for a round!

How to Double Your Money and Understanding the “Rule of 72”

How often can you expect your savings to double? It depends on one number: the rate of interest or, in investment speak, the “rate of return.”

In investment circles, there’s a formula called “The Rule of 72.” This rule dictates that the number of years it takes to double your money is equal to the number 72 divided by the interest rate. If you can grow money at a 10% rate of return, which has resembled the stock market for several years, you simply take the number 72 and divide it by 10. The result is 7.2, which means it will take 7.2 years for your money to double. At an interest rate of 9%, you can expect to wait 8 years before your money doubles (72/9 = 8). 

If you started at age 0 and lived to age 80, you could double your savings 10 times. Thus, a $5,000 deposit at birth doubled 10 times grows to $5 million by age 80.

If your parents didn’t have the foresight to put $5,000 into an investment account when you were born, you still have an opportunity to use compound interest to expand your wealth later in life. Let’s say you invest $5,000 at age 25. As your investment’s interest builds upon itself, your money will continue to grow until you retire at 65, doubling five times. That $5,000 you started with balloons to $160,000. Not bad for one year’s savings of $5,000!

Holly Hippie vs. Lonny Lawyer by Shelley Murasko

My favorite story is the one where Holly Hippie decides at age 12 to collect cans every day at her local beach. She then invests her daily can-collecting earnings of $5 into the S&P 500 index fund. She does this until age 32 when she decides to stop worrying so much about saving extra. Fast forward to age 65. Holly Hippie now has $1.6 million put aside for retirement, despite her actual savings of only $36,500 (20 years of saving $5/day x 365 days = $1,825/year).

Holly’s new friend across the street, Lonny Lawyer, takes a very different approach and decides to live it up in her 20s and 30s. She always wears the latest fashions, owns the hottest car, and eats out daily at the fanciest restaurants. Lonny doesn’t start investing until age 40. Fortunately, as an attorney, she is now making over $200,000 a year and can set aside $15,000 each year into savings until she retires at 65.

Who do you think amasses the larger amount of retirement savings? If you guessed Holly the Hippie, you’re right! Lonny accumulates $1.2 million, but Holly retires with $1.6 million, a whole $400,000 more! To add insult to injury, Holly actually put $263,000 less into savings. Clearly small amounts set aside for a long time pack a very big punch!

The moral of all these stories is to start saving something, do it consistently at a decent rate of return, and give it as much time as you can to grow. In many cases, the length of time something is invested is just as meaningful, if not more meaningful, as the actual amount saved.

If you’re a 50-something reading this article, you may feel some regret if you didn’t start saving earlier. However, with a lifespan that could go into your 90s, you still have plenty of years to benefit from the incredible power of compound interest. As the saying goes, “You’re never going to be any younger than you are today!”

With all this said, now is a great time to re-examine your financial goals. Especially if you have goals that are creating funding concerns, such as paying for college, covering 30 years of retirement, or buying a car.

By understanding the power of compound interest and the difference it can make in your financial future, you’ll feel more confident about your goals. You may even be more motivated to find money to put aside now that you or your loved ones can benefit from down the road.

For help devising an investment strategy that allows you to get the most out of compound interest, give me a call or send me an email. I’m happy to answer any questions you may have.

Source: McGee, Suzanne. August 6th, 2021. “The 6 Concepts You Should Know to Be Financially Literate” Wall Street Journal. Retrieved from The 6 Concepts You Should Know to Be Financially Literate - WSJ