Compound Interest and Einstein

Compound Interest and Einstein

My family was having a gathering and as with tradition, the elder generation tried to slot in some time to share with the younger generation some life experiences which will be beneficial for all. I decided to talk about Compound Interest and Einstein and share with my nephews and nieces.

If you have not heard about it before, Einstein basically mentioned:

“Compound interest is the eighth wonder of the world. He who understands it, earns it.. he who doesn’t… pays it.”

I asked all present if anyone has dreamed of earning $100mil is his/her lifetime, and if it is possible at all.

8th Wonder of the World

8th Wonder of the World

I made some assumptions: (1) one starts to work at age 25 and (2) one has the fortune of receiving an initial capital of $50,000 from the parent.

I showed the above chart. The first striking observation given our quest of earning $100mil is that if the initial $50k is compounded at 24% annual rate of return, $100mil is within reach in 35 years! No wonder compound interest is considered the 8th wonder of the world.

The second observation is that a small difference in the rate of return makes a huge difference in the growth of the capital over time.

What are some of the lessons here? While money is not everything in life, enough of it is important. With that context, I emphasised:

  1. Start as young as you can when investing
  2. Look for a good rate of return for your investment

Rate of Return of Investments

The current interest rate of fixed deposit (term deposit) in Singapore is about 1.2%, even less than the 2% used as illustration above. At this rate, you can see that it is not going to make your money work very hard, even compounded over 35 years. And this has not even taken into consideration the impact of inflation which diminishes your money over time.

How about buying into fundamental sound dividend stocks? If you do your homework well, you can find a number of these listed on the Singapore Stock Exchange which give 7% or so dividend rate.

Using the compound interest calculator, at 7% rate of return, $50k will compound to $533k after 35 years. This is not considering the potential capital gain in the share price of the dividend stocks purchased. This is absolutely a marked improvement over the fixed deposit option!

According to the New York Times, Warren Buffett’s Berkshire Hathaway’s per-share market value has increased by 21.6% annually over the 50 years from yearend 1965 to yearend 2014. This achievement is over a long period of time and consistency is critical in financial investments.

Warren Buffett

Oracle of Omaha

I know at this point you may start to wonder how you are going to “beat” the Oracle of Omaha Mr Warren Buffett exceeding his record of 21.6% annual investment rate of return. Well, it turns out that it is possible. As a huge company with billions and billions of dollars to manage and invest, Berkshire Hathaway will be bound by constraints, and thus affecting its returns.

As an individual investor, you can learn to achieve a higher return, and quite safely. Knowledge is key and I invite you to read our regular contributions on investments and also my reviews of VIC and OMP which have greatly improved my investment knowledge and my investment returns.

The Most Important Investment Rule

Before you get too excited to chase after the $100mil dream, let me share one investment rule expounded by Warren Buffett:

Investment Rule

When you take care of the downside, the upside will naturally come. In stock investment, there are two psychological states you have to be aware and overcome, one is Greed and the other is Fear.

In fact, if you think about it, the stock market moves up and down and this is caused by Greed and Fear. As an intelligent investor, you buy into stocks which are fundamentally sound and undervalued and you are not concerned about interim stock price fluctuations.

Start Investing Now!

The authors of Journey with Money are motivated to share what they know about investing and often we share with friends and relatives what we are doing, the events and workshops we organize.

Almost everyone will agree with us the importance of investing (and we are not limiting to stock market investment, but property market investment, commodity investment etc); however, we often hear the following objections:

  • I don’t have time
  • I don’t know how to, and I don’t think I can learn
  • I have been burned before
  • Investing is too risky, it is like gambling
  • I don’t have money to invest

To each of the above “excuses”, there is a credible rebuttal but I am more interested to point out that when we decide to do something in life and excel in it, the underlying motivation is critical.

Ask yourself if financial freedom which may lead to time freedom is going to bring you, your family and loved ones great joy; and allows you time to seek other passions in life etc.

If the answer is a resounding yes, you will find time and spend the efforts to learn and with the right knowledge, invest wisely.

And it is imperative to start the investment journey as young as one can, as time is a precious resource, obvious from the compounding interest effect.

The last point “I don’t have money to invest” may be a valid point which needs addressing. Basically, this has got to do with monthly budgeting, what you earn each month and how you control your expenses and ensure you have savings and money allocated for the purpose of investment.

In Summary

I hope this article motivates you to make your money/savings work harder in your favour through the right investing strategy and compound over time, and to start the investing journey as young as you can. Do leave me comments below as always and make us better investors collectively. Let me share the video below to nudge the young to start investing and reap the profound benefits of compound interest.

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