In this extract from their excellent new book ‘Get Started Investing: It’s easier than you think to invest in shares‘, Alec Renehan and Bryce Leske talk us through the mighty power of compounding.
Since the creation of the first company, investing in companies has been a powerful creator of wealth for millions of people. A lot of this is due to the awesome power of compounding.
You’ve decided that keeping your money in the bank isn’t the right call. You need a way for your money to work for you, to earn interest and stay ahead of inflation. The reason investing is the right call is the awesome power of compounding.
Naturally, Einstein had it all figured out
Albert Einstein was not an investor, but rather a theoretical physicist who developed the theory of relativity. A famous quote that recognises the power of compounding is often attributed to him.
‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.’
Einstein isn’t the only famous historical figure who understood the power of compound interest. Benjamin Franklin, one of the Founding Fathers of the United States, similarly understood its importance.
‘Money makes money. And the money that money makes, makes money.’
The power of compounding
Compound interest is a term we all learn at school, and a lot of us promptly forget. It is important to remind ourselves what it means.
Interest is the money we earn on our money (e.g. your bank pays you interest on your savings account). There are two types of interest: simple interest and compound interest.
Simple interest is where you earn money on the money you put in at the start. For example, if you invest $100 and have a 10% interest rate, every year you get paid $10 (10% of $100).
Compound interest is where you earn money on the money you put in at the start and all interest you are paid.
For example, if you invest $100 and have a 10% compound interest rate, the first year you get paid $10 (same as simple interest). But you then have $110, so in the second year you earn interest on the $110, so get paid $11 (10% of $110). In year 3, you get paid $12.10 (10% of $121) and it would keep growing from there.
The virtuous cycle
With compound interest you make money on the money you earn. It is a virtuous cycle where a small investment can grow into a very large amount over a long period of time.
Take the example of someone who invests $100 and earns 10 per cent interest. With simple interest you get paid $10 every year. With compound interest the amount you get paid increases every year. Over time a big difference starts to emerge:
The benefits of time
Compound interest gets particularly interesting if you can earn a consistent rate of interest over a long period of time.
As the returns grow year after year, the numbers start getting exciting.
Take our $100 invested at 10 per cent as an example:
- If you invest $100 at 10 per cent for five years, you will multiply your money by 6 times (you will have $161).
- If you invest that money at that 10 per cent for ten times as long (50 years rather than five), you will not multiply your wealth by sixteen times… you will multiply it by more than 117 times (you will have more than $10,000!).
This is because the growth of this money is exponential. By year 50, you are not just earning money on your original investment, you are also earning money on the previous 49 years’ returns. Your money is making money that is making money.
It’s definitely time you tapped into the mighty power of compounding!