Compound interest: the 8th wonder of the world
Why not leverage this mechanism?
Investing is all about investing your money with the objective to earn a return on your investment. To put it simply: your money is working for you.
The compound interest effect is a mechanism which helps you increase your wealth. When you invest your capital, you earn interest on the invested sum after the first year. This interest then gets added to the principal (= the sum you invested). Hence, the principal increases each year (and so does the interest in total terms). This mechanism works its magic each year. In the long-term this can lead to a substantial increase of your wealth.
Be patient, invest for 10 or 20 years!
The longer your investment horizon (= the longer you plan to keep your capital invested), and the higher the interest rate, the more beneficial is the compound interest effect. This is one of the main reasons why you should invest and not keep your money in a savings account (or a savings book with a low interest rate).
Let’s look at an example of the compound interest effect. Say your invested capital (= principal) is EUR 1.000. You invest it at an interest rate of 10%, and your investment horizon is 20 years. After 1 year, you have earned EUR 100 on your invested capital, so your total amounts to EUR 1100. After 2 years, you have a total of EUR 1210. Why? Because you earned a 10% interest rate on EUR 1100 (= principal after year 1). And so on…
Your initial investment of EUR 1000 will have augmented to EUR 6728 after 20 years (including EUR 5728 interest which you earned).
Sounds too good to be true? That’s why Albert Einstein referred to it as the 8th wonder of the world.
THE Rule of 72 - SO EASY!
To calculate how many years it will take to double your capital you can use the rule of 72. Note your interest rate (for example, 4%) and divide the 72 by it. 72/4 = 18. The formula is simple: divide the 72 by 4=18 (years). If your expected return is 4% it will take 18 years. We love simple rules!
Leveraging compound interest is a savvy thing to do. Why? In times of low interest rates and annual inflation of (currently) 2%, you loose money if you don’t make use of basic investing principles such as this one. So trust it! Work it!
Written by Clara Creitz
Finelles Founder. Coach and Consultant (UBS, Towers Watson).