The miracle of compound interest is what makes ordinary investments into extraordinary riches. Understanding how compound interest works will give you the same opportunities to grow your investments as Warren Buffet or any other investment guru does. The article will help you understand the importance of investing early and the impact that compound interest can have over time on your investments.
Remember building wealth is not based on a decision; it is an accumulation of multiple choices over an extended period. By planning your investments, so they have time to compound, you are better able to put money to work for you, and build your wealth. If you leave your money invested long term in savings or investments, it will grow. The returns from those investments will have the chance to compound, generate growth over as long as it's invested, and help you meet your long term goals.
As a college professor, I use to teach my students about the importance of investing as soon as they could. As an example, I would ask if any of them would help me paint my house for one penny if I doubled the amount every day for 30 days? Most would say "No". Then I would pull out a calculator and on the projector and demonstrate precisely how it works. One penny would become two pennies on the second day, four pennies on the third day, and at the end of one week, it would become sixty-four cents. Some of the students would be feeling pretty confident that they chose not to take the job starting at one penny. However, by the thirtieth day, they would have gotten $5,368,709.12 with only three weeks more.
The idea is that time is finite, and we all have a limited amount of time in the world. Someday all of us are going to die, so we need to use our time wisely, especially when it comes to investing. The longer your money is allowed to remain invested, the more time it is going to have to grow over an over again on not just the principle but the additional interest earned as well. That's why it's called compound interest its like a snowball turning into an avalanche.
If you consider the Standard Poors index or S & P index, it has averaged around 10% gains per year since it started about 90 years ago. Although the stock market has up and down years its the result that matters. With this in mind if an 18-year-old invests $10,000 in an S & P index fund when he graduates from high school instead of buying his first car. He or she will have around $1,000,000.00 by the time he or she retires a few months after their sixty-sixth birthday.
Warren Buffet has some of the best examples of compound interest. The first story is the story of the Mona Lisa. If instead of painting the Mona Lisa in 1516, King Francis’ had invested his initial $20,000 investment at a 6% interest rate, his investment would be worth over $1 quadrillion.
Another example was Christopher Columbus's journey to the new world. If Queen Isabella had invested her $30,000 at 4% interest instead of in Columbus's voyage, then her investment would be worth $7. Trillion.
Albert Einstein called compound interest the eighth wonder of the world, and added, “He who understands it, earns it. He who doesn’t pays it.” Because even at low interest rates, a small amount of money can grow into vast amounts of money. If the smartest man ever and the greatest investor ever think this compound interest is important then its something that every investor should become familiar with to build up their your wealth.
Compound interest is what Warren Buffett calls his greatest financial secret and his single most powerful factor behind his investing success. The indispensable component about compound interest is that once you invest some money, it allows you to earn interest on your interest. So, while you hustle to make money to invest, from then on your cash works on your behalf on autopilot. For compound interest to be even more effective, keep adding cash as you can, reinvest dividends (also helps you incur more taxes), and invest over the long term.
If you don't’ capitalize on compound interest, then you are most likely capitalizing on inflation and inflation is not your friend. Inflation is a general increase in prices over time, and as this happens, it erodes the purchasing power of your money. The USA averages around 3% inflation in a year which basically means, if you have one dollar saved at the end of the year, that dollar is worth 0.97 cents, because you lost 3% of its ability to buy things.
The famous American baseball player, Babe Ruth of the New York Yankees, was paid $35,000 for the 1943 season. Recently Mike Trout, the Los Angeles Angels baseball star, signed a $430,000,000 contract in 2019. This comes out to just over $35,000,000 a year When Babe Ruth signed his contract, the average price of a house in Los Angeles was just over $6,000 dollars. In 2019, when Mike Trout signed his contract, the average price of a house in Los Angeles was just under $600,000. This means that the price of a house has increased about a hundredfold, while the salaries of baseball players have gone up over thousandfold. As inflation has eroded the value of money over time, prices have to go up to be able to make up for the lost purchasing power.
If Babe Ruth had tried to get into the Southern California real estate market, he would have been able to buy about 6 houses the year he signed his contract. Had he decided to save his money in the bank instead, the Babe wouldn’t even have had enough for a downpayment on a house in Los Angeles, which would come out to around $120,000. If Mike Trout doesn’t invest his money, we’ll be having the same conversation about him in 76 years.
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