The power of compound interest

Aug 14, 2017 | Tony Byrne's View

‚ÄúCompound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.‚Ä̬†Who is attributed with having made this statement? Why the great Albert Einstein no less!¬†Surprising eh?¬†In fact there is no documentary proof that Einstein actually said this but it is plausible because it is so profound and so true.

Compound interest is so important it should be one of the first things every child is taught in a maths lesson at school. Of course I recently wrote a blog on the Rule of 72 which was a lesson in both compounding and discounting. I just wanted to focus on the power of compound interest this week.

I once read the story about a young computer genius who was writing a big and complicated software program for a business client. Instead of agreeing a large fee of £300K-£400K for the project he asked to be paid a penny for the first day and for that penny to double every day for the 31 days of the month. Naturally the entrepreneur thought that was a good deal so he agreed the terms with the young man.

Although the businessman was highly successful in his chosen field of work he clearly didn’t fully appreciate the power of compound interest.¬†He hadn’t worked through the figures assuming that the amount he would have to pay would be less than ¬£300K-¬£400K being the market rate for the job.¬†His approach was naturally the right thing to do wasn’t it?¬†Was there really a need to run through the figures?¬†Surely the final price couldn’t be more than that could it?¬†What would you have done?¬†Accepted the young man’s terms?¬†If your answer is yes then think again.

Here are the numbers.

Day 1 1p

Day 2 2p

Day 3 4p

Day 4 8p

Day 5 16p

Day 6 32p

Day 7 64p

Day 8 £1.28

Day 9 £2.56

Day 10 £5.12

At this point the businessman is smiling thinking he’s got a great deal but look at what happens next.

Day 11 £10.24

Day 12 £20.48

Day 13 £40.96

Day 14 £81.92

Day 15 £163.84

Day 16 £327.68

Day 17 £655.36

Day 18 £1310.72

Day 19 £2621.44

Day 20 £5242.88

It’s surprising how fast the numbers are starting to grow but surely the final figure will be lower than the market rate won’t it?¬†Think again.

Day 21 £10485.76

Day 22 £20971.52

Day 23 £41943.04

Day 24 £83886.08

Day 25 £167772.16

Day 26 £335544.32

Day 27 £671088.64

Day 28 £1342177.28

Day 29 £2684354.56

Day 30 £5368709.12

Day 31 £10737418.20

Well would you believe it?¬†The entrepreneur may have been successful in business but he certainly did not understand the power of compound interest whereas the young maths genius clearly did!¬†What an expensive lesson for the business man.¬†I bet he never made that mistake again.¬†Let’s hope the program was such a success that he was not only able to pay the fee but also profit from its success.

Whatever you do, don’t ever underestimate the power of compound interest.¬†We have many clients’ whose investment portfolios under our management have doubled and doubled and doubled over the last 20-30 years since we first started working for them.¬†They will happily testify as to the vital importance of compounding as it has enabled them to not only become financially free but also to live the retirement lifestyle of their dreams and enabled them to leave money to their heirs so that they too can live the life of their dreams.

The average annual return a medium risk investor client of ours has achieved over the last 21 years has been 9.8% or 8.8% net of our 1% p.a. adviser management fee using our Wealth Investment Strategy. That means their investments have doubled in value approximately every 8 years or so. So after 16 years their portfolios have quadrupled and after 24 years they have octupled! That means an increase of 8 times their original investment or in percentage terms 700%!

That’s the power of compound interest.¬†It truly is the 8th wonder of the world whether Albert Einstein in fact said it or not.

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