Imagine for a moment that you’re at a ski resort in the Swiss Alps.
You’re standing at the peak of the mountain, looking down into the beautiful valley below. For no clear reason whatsoever, you decide to make a snowball and chuck it at your friend’s face. Just kidding. You actually roll it down the steep slope of the mountain and begin your observation.
As it starts rolling down, the snowball begins to gradually pick up speed. It’s an innocent little snowball at first, and then all of a sudden, it starts accumulating more and more snow and grows larger at a increasing rate. It becomes huge and uncontrollable, and when you realise the amount of damage the snowball could cause, you decide to leg it before anyone notices you.
Notice how the snowball started off really small but grew rapidly without you having to do anything at all. The steeper the slope of the mountain, the faster the snowball would grow right?
Now imagine if you could do this with money.
The Power of Compound Interest
This is essentially the main idea behind investment. The snowball is your money, and the mountain is the investment vehicle that you choose. The steeper the mountain, the faster the snowball will grow. The “mountain” could be stocks, bonds, and a hundred other examples, but for now let’s just focus on the idea of the snowball effect.
The snowball effect would be compound interest, and that’s the topic of today’s post.
Basically, that little anecdote about the snowball was my way of understanding compound interest. It’s an extremely simple, yet powerful concept, which, once understood, can be applied to your wealth to allow it to grow pretty much automatically.
Let’s begin with simple interest, which is the most basic form of interest. If you have $100 in the bank with a simple interest rate of 10% (Note: Banks usually use compound interest, not simple interest), at the end of every year, you would receive a flat $10 dollars.
The table below demonstrates the example.
|Beginning Investment||$ 100.00|
|Interest Rate Per Year (In Percentage)||10|
|Results/ Future Value:|
|Year 1||$ 110.00|
|Year 2||$ 120.00|
|Year 3||$ 130.00|
|Year 4||$ 140.00|
|Year 5||$ 150.00|
|Year 6||$ 160.00|
|Year 7||$ 170.00|
|Year 8||$ 180.00|
|Year 9||$ 190.00|
|Year 10||$ 200.00|
Compare this with compound interest, which would give you 10% on the cumulative balance of that year. So if you had $100 to start with, in year 1, you’d receive $10. In year 2, you would receive 10% of the cumulative balance, which is now $110. So this, year, you’d get $11, bringing your cumulative total to $121.
Here’s another table to the rescue. Over 10 years, this is how your initial $100 would grow, completely untouched.
|Interest Rate Per Year
|Results/ Future Value:|
At the end of 10 years, you end up with $259 dollars. That’s 29.5% more than than what you would have received from just simple interest. Over time, compound interest is extraordinarily powerful. At the end of 50 years,that same $100 turns into an astounding $11 739.09, whereas with simple interest, it would be a measly $600.
I’ve created an Excel sheet of a compound interest calculator which you can download and adjust all the values to see the effect of compounding. Alternatively, you can simply Google “compound interest calculator”, but this one shows you exactly how much the initial amount grows each year like in the example above.
Now that you understand the concept of compound interest and why it is so powerful, I’ll introduce you to the easiest way to get started with investing, even if you have no knowledge at all. That will be coming up in the next post, in which I will be explaining exchange traded funds or ETFs and how you can use them to start your investment journey.