Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn't, pays it.
- Albert Einstein
Compound interest is a very simple concept but is often difficult for the average investor to conceptualize and adhere to. It takes discipline, patience, and a very long time for the effects to become evident. Human nature and our aspiration for short-term gratification make it nearly impossible to reap the benefits of compound interest but it is on this basis that many of the most successful businesses have grown.
Compound interest is the addition of interest to the principal on an investment, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. To illustrate, in year 1, if you invest $5,000 and earn 8%, after year one you will have $5,400. In year 2, you earn 8% again (but this time on $5,400), and after year 2 you have $5,832. In year 3, you earn 8% again (but this time on $5,832), and after year 3 you will have $6,298.56. This continuous compounding can lead to great returns over long periods of time.
This simple illustration below shows the enormous effect of compounding over long periods of time. This illustrations shows the savings (and investment!) of $5,000 annually over 45 years growing at a rate of 8%.
Why is it so difficult for investors to see the full effect of the 'eighth wonder of the world'? Simply, it requires the foregoing of current consumption (ie., buying a new pair of jeans, going for a nice dinner, or vacation), and instead investing this money for future consumption. Our short-term minds can't help but spend now.
More conservative spending now will allow the benefits of compound interest to add to your families wealth. The chief component behind the magic of compounding is time and discipline. So start with a savings discipline now and let the magic begin.
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