Compound Interest

A Famous Quote on Compound Interest

Albert Einstein, one of the greatest physicists of all time, has a famous quote: “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

No one has challenged this quote.  We can say it’s an undisputed truth. 

Warren Buffett, considered one of the most successful investors in the world, said: “Time is the friend of the wonderful company, the enemy of the mediocre.”  

Do you know he has been investing since he was 10 years old and 98% of his wealth was accumulated after the age of 50?

There are many other quotes on compound interest or interest compounding made by other famous people. 

Do you know how compound interest works?

Have you been making the best use of compound interest to build your wealth, as Warren Buffett has been doing?

If your answers are no to both of these 2 questions, then your financial freedom journey will be many times harder.  You may never get close to financial freedom. 

Return on Investment Based on Historical Market Return Rate

Table 1 shows the Total Returns 1917Q1-2019Q1 Australian Securities Exchange (ASX).   We will use the average ASX annualised total market return of 10.2% in Table 1 to illustrate the power of compounding. 

Let’s say you had inherited $10,000 (Note: all currencies in Australian dollars) 50 years ago and had decided then to invest all $10,000 in a small group of ASX blue-chip stocks.   You had been receiving an average annualised return of 10.2%, which was a reasonable return consistent with the average total market return, over the last 50 years.  You had been reinvesting all the dividends received in the last 50 years.  Dividends were part of the total market return of 10.2%.

Figure 1 shows that the value of stock holding today, 50 years after your initial investment of $10,000, would have been $1,285,523. 

You would have been a millionaire!  Can you believe this?

Let’s analyse the 10-year growths to better understand the power of compound interest.

Table 2 shows the return in the last 10 years (i.e., Years 41-50) would have been $816,819, compared to the first 10 years (i.e., Years 1-10) of $16,413. 

The last 10-year growth was almost 50 times more than the first 10-year growth. What a huge difference! 

It was the exponential nature of compounding effect that had given rise to the huge difference. 

Let’s say you had invested $10,000 40 years (instead of 50 years) ago.  Table 2 shows that your stock holding value today would have been $468,703.  This was less than half of what you would have received in 50 years. 

What have we learned from this? 

To maximise the power of compounding, you need to give it time.  You need patience and discipline to let time works its magic.  You need perseverance and sacrifice to keep building your wealth to reach financial freedom.     

What if your investment had matched Warren Buffett’s Rate of Return Consistently?

It has been well reported that Warren Buffett’s Berkshire Hathaway has been getting an average return on investment (ROI) of 20.5% since its inception.   This means that Berkshire Hathaway has been consistently outperforming the market ROI by approximately 10%.

Let’s find out your stock holding value today if you had invested $10,000 50 years ago at an average ROI of 20.5%.

Figure 2 shows that the stock holding value today would have been $112,034,646. 

This is almost 10 times more than the value at an average annualised market return of 10.2%!  What a huge improvement!

Now we understand why Warren Buffett said: “Time is the friend of the wonderful company, the enemy of the mediocre.” 

Warren Buffett has been investing for the last 75 years.  So, what would an initial investment of $10,000 have been after 75 years of average ROI of 20.5%? 

Figure 3 provides the answer.  Yes, the initial investment of $10,000 would have been almost $12 billion!  Wow!

You must be curious what Warren Buffett regarded as “wonderful companies” that have consistently helped him achieve an average ROI of 20.5% over so many years?  Check out the Berkshire Hathaway website.

Mathematics of Compounding

To appreciate the power of compounding, you need to understand the mathematics of how compounding effects work.  The mathematics of compounding shows why time is so important. 

The compounding formula is as below:

Where A is the compounded amount, P is the initial amount, r is the annual rate used for compounding, t is the number of years, and n is the number of compounding within 1 year. 

For simplicity of illustration, let’s take n=1 for 1 compounding annually.  You can see that the compounded amount is an exponential function of time.  That means the power of compounding will increase over time.

OK, you did not inherit $10,000 50 years ago.  However, you have been saving and investing $1,000 every year without fail in a small group of ASX blue-chip stocks for the last 50 years.  You have been reinvesting all the dividends you had received.  What would have been your stock holding value today?

Figure 4 gives you the answer.  Your stock holding value would have been $1,379,065 today.

You would have been a millionaire too! 

It is important to know that instead of a one-off initial investment of $10,000, you would have been investing a lot more (i.e., $1,000 X 50 = $50,000) over 50 years. 

Figure 4 shows that the compounded amount is also an exponential function of time.  In fact, here the compounded amount is the sum of a series of exponential functions of time.

Dollar Cost Averaging

The approach of saving fixed amounts of $1,000 at fixed times every year over the last 50 years is called Dollar Cost Average.

The rationale of Dollar Cost Average is that you will buy more shares at low prices and fewer shares at high prices.  Timing the market becomes less important.  And the requirement is that you will need to do this over a long time over many economic cycles.

Dollar Cost Average is a great way to keep you disciplined with your spending habits and saving regularly. 

Your perseverance and sacrifice will eventually pay off in building your wealth towards financial freedom.   

Why so Many Investors Consistently Ignore Compounding?

There is a range of reasons:

1. They fail to understand the mathematics of compounding and therefore they never understand and are unaware of what compounding can do.
2. The compounding effect of investing or savings in the short term is almost invisible.  Therefore, compounding is boring in the short term to many people because they don’t see much effect of compounding in the short term.  Generally, most people have insufficient patience to wait for the growth of their investments over time.  They are more interested in short-term gains from the stock market through buys and sells.  They may think a realised gain of $100 from selling stocks is money in their pocket right now.  To them, the short-term $100 gain now is more exciting and rewarding than having to wait for compounded gain in the long term. 
3. Many investors believe they can time the market.  These investors who follow the market and read about market reports believe they can time the market better than other investors to make short-term gains.  The excitement from getting the right timing to enter and exit the market makes these investors trade more often.    
4. All of us have competing needs that require money to spend at every point in our life.  We want to enjoy a holiday, buy a nice TV set, renovate our kitchen, buy a nice car, etc.  Our priority in life may prompt us to spend the money now or soon rather than leaving the money invested for the long term.

Rule of 72

Rule of 72 is a quick and simple way to calculate the number of years required to double the invested money at a given annual rate of return.  Divide 72 by the rate of return and you will get the number of years. 

If an investment will give you a rate of return of 4%, the invested money will take 18 years (i.e., 72/4=18) to double.  If you invest $50,000, you will receive $100,000 in 18 years.  Simple?  Yes. 

Rule of 72 can also be applied to inflation or anything that grows, such as Global Domestic Product (GDP) or population or COVID-19 infection cases.

At an inflation rate of 3% annually, your money will lose half of its value in 24 years.  What this means is your real purchasing power will be reduced by 50% in 24 years. 

If inflation goes up to 4%, your real purchasing power will be reduced by 50% in 18 years.

An investment fund that charges an annual fee of 3% will reduce the investment principal to half in 24 years.

A credit card holder who pays 12% annual interest on his credit card balance will double the amount he owes in 6 years.

To build wealth to achieve financial freedom, you must always let compounding work in your favour and avoid letting compounding work against you.

Effect of Inflation

Because of the compounding effect, inflation will reduce the real purchasing power of your income if your income stays the same.  Your future wealth will be eroded by inflation.  

You need to stay ahead of inflation.  How? 

Your investment return must be greater than inflation.  Your investment return should be calculated at net return above the inflation, which is often referred to as the real return adjusted for the purchasing power, as opposed to nominal return.  A nominal return is a return that ignores the impact of inflation.

Referring to Table 1 earlier, the average annualised consumer price inflation was 3.9% and the average annualise nominal market return was 10.2%.  To account for inflation, the average annualised real market return was 10.2% – 3.9% = 6.3%. 

Let’s take a conservative approach and build a 10% buffer in our calculation by using the average annualised real market return of 5.67% (i.e. 90% of 6.3%) for the next 50 years.

Expected Future Return on Investment

Let’s say you are 25 years old today.  You believe you will need $1m to retire comfortably at age 65 in today’s dollars representing today’s purchasing power.  How much will you need to invest today? 

Figure 5 gives you the answer.  You will need to have a one-off initial investment of $115,000 today and you will continue to reinvest all the dividends you will receive for the next 40 years.

The value of your investment is expected to be $1,044,158, in today’s dollars representing today’s purchasing power, when you turn 65.

OK, you don’t have $115,000 but you are determined to save and invest a fixed amount and all the dividends to be received every year for the next 40 years until you reach 65. 

How much will you need to save and invest every year to be a millionaire, in today’s dollars, when you turn 65?

Figure 6 gives you the answer.  It will be $6,800 every year and you will reinvest all the dividends you will receive. 

The value of your investment is expected to be $1,030,727, in today’s dollars representing today’s purchasing power, when you turn 65.

What if you are 35 years old today and you want to have $1m, in today’s dollars representing today’s purchasing power, to retire comfortably at age 65?  How much will you need to save and invest every year?

Figure 7 gives you the answer.  It will be $12,800 every year and you will reinvest all the dividends you will receive. 

The value of your investment is expected to be $1,022,007, in today’s dollars representing today’s purchasing power, when you turn 65.

The biggest hurdle is to make the first step.   

Promise yourself to start today, start saving, start investing, start the wealth-building journey towards financial freedom. 

Have a closer look at Figures 1 to 6.  Have you noticed the longer the timeframe, the steeper is the curve?  Figure 3 shows that the curve bends upward sharply in years 60-70. 

Imagine if you will allow compounding to go on 100 or 200 years.  The curve will be so steep it will be almost vertical! 

The power of compounding is so clearly demonstrated.

When you will allow more time, the power of compounding will work harder for you.  Never interrupt compounding unnecessarily.

Let’s use this new and fresh understanding of compounding to look at some favourable and adverse financial impacts.

Australian COVID-19 Superannuation Early Release Scheme

Under the scheme, Australian Superannuation account holders can withdraw up to $20,000 from their Superannuation funds in two tranches. 

Figure 8 shows that the Australian Prudential Regulation Authority (APRA) recorded a total of 4.9 million withdrawals amounting to $36.4 billion as of 31 Jan 2021.  In the 4.9 million withdrawals, 1.4 million were repeat withdrawals.

Many people withdrew the maximum allowed amount of $20,000.   Many emptied their superannuation accounts. 

Sadly, for many, it was the only way to get that extra cash they need to survive the economic hardship. 

However, for many who have other options but opted to withdraw from their Superannuation account, they will regret their actions many years down the line.   

Are you one of those who withdrew $20,000 or emptied your Superannuation account?

Let’s say you are at the of age 30 now and have withdrawn the maximum total amount of $20,000.  This $20,000, in 35 years from now, when you reach the age of 65, could be $78,921 based on a historical annual Superannuation real return of 4%.  $78,921 would be in today’s dollar representing today’s purchasing power.

The early withdrawal will be a great setback to your retirement plan and your retirement lifestyle. 

This is a compounding effect working against you.

Superannuation is one of your biggest assets.  You will rely on your Superannuation for your retirement years. 

You may want to consider making extra Superannuation contributions to replenish that $20,000 or whatever amount you have withdrawn.

Failing to Pay Credit Card Balance on Time

You should know that typical credit card interest charges are 10-24% annually.  Clearly you don’t want to incur unnecessary interest charges. 

Therefore, if you have a credit card, always pay the full credit card balance every month and not the minimum balance payment.  The minimum balance payment is designed for the credit card companies to earn as much as possible from you. 

In addition to incurring very high interest charges, failing to pay the full credit card balance by the due date will mean a bad credit rating for you. 

Consider credit card outstanding bill of $5,000 with 2% monthly interest.   You will pay interest of $100 every month or $1,200 a year.  Applying the rule of 72, your credit card bill will become $10,000 in just 3.6 years. 

What if you have a credit card bill of $5,000 EVERY month? 

You will sink in debt that you cannot repay! 

You need discipline and self-control!  Don’t buy anything you don’t need.  Always pay down all outstanding monthly credit card balances. 

Set automatic full payment of credit card balance so you don’t have to worry about missing paying credit card bills.

Some people invest their spare cash in stocks while paying high credit card interest charges.  It is an illogical move.  The rate of return in stocks is unlikely to be high enough to offset the high credit card charges.  They should be using their spare cash to pay off their credit card balance instead of investing their spare cash in stocks. 

No one but you is responsible for your financial affairs and for managing your finances. 

Don’t assume your tax agent or accountant will be able to advise on all your finances. Don’t pass on your responsibility to your tax agent or accountant. 

Be on top of your finances.

To make a sound financial decision, you will need to know all of your assets and liabilities, all the information regarding the returns on your assets, and all the costs you pay on your liabilities. 

How About Saving Home Downpayment for Your Son and Daughter?

The Australia Talks national survey conducted recently has found that 65% of Australians think owning a home is no longer an option for most young Australians as property prices rise.

Australian homeownership rates among 25- to 44-year-olds had declined sharply between 1986 and 2016.  Homeownership among 25- to 55-year-olds is expected to decline to just above 50% by 2040.

What about giving a hand to your newborn son or daughter by paying for the downpayment for his or her home when he or she turns 25? 

Let’s assume you want to build up a saving of 20% downpayment towards a home priced at $800,000 in today’s dollars 25 years later.  That downpayment is $160,000 in today’s dollars. 

What is the initial investment you will need today?

You will need $41,000 today, based on an annual real stock market return of 5.67% (i.e., 10% buffer off the historical annual real stock market return of 6.3%).  You will reinvest all the dividends you will receive.  $41,000 is expected to turn into $162,771, in today’s dollar, in 25 years.

Maybe a more modest home 25 years later priced at $500,000 in today’s dollars? 

You will need $26,000 today, based on an annual real stock market return of 5.67% (i.e., 10% buffer off the historical annual real stock market return of 6.3%).  You will reinvest all the dividends you will receive.  $26,000 is expected to turn into $103,221, in today’s dollars, in 25 years. 

That downpayment will surely be a very precious gift for your newborn son or daughter 25 years from now.

How About Saving Retirement for Your Son and Daughter?

OK, you have already achieved financial freedom and you want to do more for your newborn son or daughter. 

You know about compounding and you know it is easier to start saving and investing now for their retirement 65 years later. 

You want to create a retirement fund of $1m, in today’s dollars representing today’s purchasing power, for your newborn son or daughter when he or she turns 65.

How much will you need today?  You will only need $28,000.

You will save and invest $28,000 today and you will reinvest all the dividends you will receive.  And you are expected to receive $1,009,297, in today’s dollars representing today’s purchasing power, when your son or daughter turns 65.  This is based on an annual real stock market return of 5.67% (i.e., 10% buffer off the historical annual real stock market return of 6.3%). 

It sounds good. 

With $28,000 today, you could help your son or daughter living a comfortable retirement with an expected compounded amount of $1,009,297, in today’s dollars representing today’s purchasing power, when he or she turns 65.

How About Setting up a $1b Scholarship Fund 200 years from now?

OK, you want to leave a long-lasting legacy.  You want to set up a scholarship fund (or a fund to support a social cause you wish to promote) of $1 billion in today’s dollars in your name after your passing, 200 years from now. 

How much will you need today?  You will only need $16,300.  Can you believe this?

An ordinary person could afford to do this.

You will save and invest $16,300 today and will reinvest all the dividends you will receive in the next 200 years.  This very modest $16,300 is expected to turn into $1,005,840,432, in today’s dollars representing today’s purchasing power, in 200 years from now, based on an annual real stock market return of 5.67% (i.e., 10% buffer off the historical annual real stock market return of 6.3%). 

Yes, only $16,300 today! 

The power of compounding interest at full display!

OK, you don’t want to wait 200 years.  What about 100 years?  However, you will need to scale down the scholarship fund to $10 million in today’s dollars.

You will save and invest $41,000 today and will reinvest all the dividends you will receive in the next 100 years.  $41,000 is expected to turn into $10,184,849, in today’s dollars representing today’s purchasing power, in 100 years from now, based on an annual real stock market return of 5.67% (i.e., 10% buffer off the historical annual real stock market return of 6.3%). 

What extra 100 years could do to your scholarship fund?

What about a charity organisation of your choice 100 years from now?

Interest compounding could do wonders for you.

Concluding Remarks

Now you know the power of compounding, you should know starting later means lost opportunity and could be costly.  The sooner you start, the more time compounding will work in your favour, and the wealthier you could become.

Start right now. 

Money should work hard for you, but you will have to start saving and investing to make money work hard for you.

Getting started is the hardest first step.  It is never too late. 

If you are young, you will have the advantage of the time to ride through the ups and downs of the stock market and the economic cycles. 

However, if you are at age 40, you will still have a very long time for compounding to work for you.  You will have to work a lot harder and will have to invest a lot more to have the same results.

Take the first step, which is to start saving and investing.

You want to make compounding work for you and not against you.  Use compounding interest to create wealth for you.  Be aware of compounding fees and inflation that will work against you and will destroy your wealth.

Compounding could allow you to leave an everlasting legacy or a precious gift for your loved ones.  The amazing thing is you don’t have to be very rich to do so. 

Just make compound interest work hard for you in your financial freedom journey.

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