Albert Einstein said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
There are 3 aspects of compounding that, I believe, could be better understood.
- Rate of return matters: Most people believe that saving is enough and compounding will automatically work for them.
10,000 invested for 20 years
- @ 4% it will be 22,000 – this is about 2X
- @ 8% it will be 47,000 – this is about 5X
- @ 12% it will be 97,000 – this is about 10X
- @ 16% it will be 196,000 – this is about 20X
Rate of return on investment has a great influence on the final amount one will have, hence the choice of investment vehicle is very important.
- Duration matters: For a large snow ball to form height of the mountain is very important. Similarly the number of years the funds are invested is very important
10,000 invested @ 8% for
- 5 years it will be 15,000 – this is about 1.5X
- 10 years it will be 22,000 – this is about 2.2X
- 15 years it will be 32,000 – this is about 3.2X
- 20 years it will be 47,000 – this is about 4.7X
- Last few years are the most important: This is the least understood aspect of compounding. The last few years are more important than the first few years.
Return on 10,000 invested @ 8% for 20 years will be about 37,000.
- 1 – 5 years it will be 5,000 – this is about 13% of total return
- 6 -10 years it will be 7,000 – this is about 19% of total return
- 11-15 years it will be 10,000 – this is about 28% of total return
- 16-20 years it will be 15,000 – this is about 41% of total return
Return in the last 5 years represents over 40% of the total return, understanding this will help investors being patient with their investments.