My first few blog posts will deal with the foundation of finance. Once you understand these foundations, it will make a huge change in your life and outlook on money. One of my favourite things in the world is called compound interest, yes I know I am a nerd, but it really gets my blood boiling, as it is a huge phenomenon. I think I am not the only one who shares this fascination on compound interest. Albert Einsten once said:
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
My goal in this article is to get us all very comfortable around compound interest and its capability of changing your life.
I think the best way I can illustrate this without going into too much financial jargon is to create a picture for you.
If I had to offer you a job today and ask if you would work for me if I had to pay you 1 cent per day and double it everyday for a full month. What would your answer be?
Well let’s look at it a little closer…
Have a look at the table below according to what I would be paying you each day of the month.
Day 1= 1c
Day 2 = 2c
Day 3= 4c
Day 4= 8c
Day 5= 16c
Day 6= 32c
Day 7= 64c
Day 8= 1.28
Day 9= 2.56
Day 10= 5.12
Day 11= 10.24
Day 12= 20.48
Day 13= 40.96
Day 14= 81.92
Day 15= 163.84
Day 16= 327.68
After 17 days, you would have made a total of R1310.42 (or R38.55per day), so this is really nothing special so far. But look what happens next as the compounding effect really starts kicking in.
Day 18.= 1 310.72
Day 19.= 2 621.44
Day 20.= 5 242.88
Day 21.= 10 485.76
Day 22.= 20 971.52
Day 23.= 41 943.04
Day 24.= 83 886.08
Day 25.= 167 772.16
Day 26.= 355 544.32
Day 27.= 671 088.64
Day 28.= 1 342 177.20
Day 29.= 2 684 354.40
Day 30.= 5 368 708.80
Day 31.= 10 737 417.00
Do I have your attention yet?
For those of you who said yes to being paid 1c per day and doubling it each day, would have made a total of R21 474 836.18 for the month or R692 736.65 per day. I know that I am really only touching on the basics of compounding and all you analytical guys will most probably have way more technical formulas to get the concept across but I am sure that you get the basic concept through this illustration.
In essence what compound interest really is, is your interest that you gain through investments attracting more interest on top of that. This then leads you to the point where your money is making money for you, instead of you working hard for money all the time.
Now the problem with this is that most people get despondent by day 17 (or I like to turn the days into years when it comes to investing) and throw in the towel and start looking for a new job, because R38.55 per day is really not going to pay the bills. However if you had the patience to stick around and let the compound effect take place you would have made more money than you could ever have imagined in one month.
My two cents in this article is the following, when people invest today, what happens is you get to 17 years down the line and you are not happy with the results so what people do is stop the investment and start all over again with a new investment. My plea to you is unless the investment is really doing badly and a Certified Financial Planner® has suggested that you move out of that investment, please don’t stop the investment to restart from day one or year one all over again. All you are doing is attracting new policy fee costs (this is normally paid within the first 5 years of the policy) and starting the compounding ladder from the very beginning again.
The best thing you can do regarding investing is start as early as you can and stick with the investment as long as you can to get the best effect from compounding interest on the investment
I will end off with a very simple example to illustrate my point. If you had to take R100 000 today and invest that for the next ten years at a return of 10% per year, you would get an amount of R313 076 after reinvesting dividends. If you had to take the same investment and do it for 20 years, so double the period, what would the result be? Most of us would just double the R313 076 and come out at R626 152. However the outcome would be more than three times the amount at R980 169 after reinvesting all dividends.
Therefore, start investing as early as you can and try and let the compounding do the work for you!
If you enjoyed this Article, have a look at these articles:
All Video Clips Supplied by Allan Gray
July 21, 2014
Grant van Zyl