Compounding: “It’s the eighth wonder of the world: He who understands it earns it, and he who doesn’t pays it.”
Albert Einstein knew that compound interest was the true secret to making money. I’m going to run through how you can earn it and then, hopefully, you will avoid paying it in debt.
How does compounding work?
Compound interest is a financial wonder that allows investors to magnify returns over time. Essentially, it’s when the interest you earn on invested capital is re-invested and then goes on to earn more interest – ‘Money makes money, and the money that that money makes, makes more money!’
Over time, this interest-on-interest approach leads to exponential financial growth. Conversely, it also expands the debt you owe over time so it’s worth bearing in mind on all fronts.
How much growth can compounding achieve?
To demonstrate the phenomenal financial impact compounding can have, it’s best to see how it applies in real-life scenarios.
For this scenario, all investments grow at 7%. I know this is quite an ambitious growth figure, but this is just to provide large enough numbers to effectively emphasise the impact.
Let’s take two investors who have vastly different approaches to their finances – Olivia and James. Olivia wants to be a financial planner when she is older, so at age 20 she decides to get ahead of the game and begin investing. She invests £100 every month until she is 30. When she reaches her 31st birthday she then decides to stop saving entirely and leaves the current pot of money to continue growing, until she reaches age 70.
James, on the other hand, is similar to most people I know, and believes that he will earn more when he is older. As such, he decides to put off organising his finances until he reaches age 30. When his 31st birthday arrives, James then also begins saving £100 each month. However, James never stops contributing – he saves every single month right up until his 70th birthday.
Now, the results are where these different approaches become quite remarkable. Incredibly, Olivia will have £27,000 more than James on her 70th birthday. This means that simply by beginning to invest earlier than James, Olivia has made up for almost four decades worth of saving!
Visualising compounding’s impact
There are several other astounding mathematical examples out there for the visual thinkers amongst us; my personal favourite being the ‘paper example’:
Imagine that you are folding a piece of paper. Each time you fold this piece of paper, the thickness doubles. Now imagine that this piece of paper is large enough to be folded 42 times. Due to the compounding effect, the paper would be so thick that it reaches the moon.
If you then found another, astronomically large piece of paper, that you were able to fold 103 times, this piece of paper would be larger than the observable universe!
These pieces of paper increasing in size with each fold is exactly what is happening to your money each year with compounding. Each fold represents interest being credited to your existing fund, over and over again.
Next time you take a glance at your finances and think “Oh I’ll leave sorting that out until next year,” just know the huge financial impact that missing out on this eighth world wonder might have.
When it comes to compounding – time really is money…
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