He who understands compound growth “earns” it
He who does not understand compound growth ”pays” it
(Allegedly spoken by Einstein)
The power of compounding is very important to long-term wealth creation. Most financial gurus get ecstatic about compound interest and often refers to it as the “eighth wonder of the world”. Let’s therefore take a closer look at this phenomenon. Many readers may already be familiar with compound growth. For those who are not, it is important that we discuss / analyse this in some detail. We will do this at the hand of a simple calculation.
The word “compound” in compound interest comes from the idea that interest previously earned is added to the principal (starting amount). Compound interest is simply a series of simple interest calculations that are connected.
The following example will make it very clear;
You decide to invest a R1 000 (principal) at the beginning of each year for the next 20 years and the offered (by the financial institution) interest rate is 10% per year. You further decide to leave the interest in your account to earn interest together with the investment amounts made by you over the 20 year period. At the beginning of year 1 you have R1 000 and at the end of the year 1 you receive R100 in interest and you then have R1 100 in your investment account.
At the beginning of year two you invest a further R1 000 which is now added to your existing investment of R1 100. You then have a total of R2 100 which will earn interest in the second year of the investment. At the end of the year 2 you receive R210 in interest which is now added to your R2 100 and you then have R R2 310 in your investment account. You can now continue and repeat the process for the remaining years. The results are summarised in the table below:
Please note how the interest which you left in your account to earn interest together with the investment amounts, contributed to the overall growth of your investment. Money invested generated returns which when reinvested achieved further returns (compound growth). Compounding is an exponential function rather than a linear one and the longer investors have to to invest the greater the potential to significantly increase their wealth.
Needless to say, compounding works in the opposite way when you borrow money and have to repay it over years.