How Compound Interest Can Work For You
Albert Einstein is said to have said: “Compound interest is the eighth wonder of the world. Whoever understands it wins it; whoever does not, pays for it. (even if we are not sure he was the one who really said that.)
As an investor, making your money work for you is the best way to increase your wealth. And the wealth you will accumulate is the result of 2 things: how much time do you invest and the rate of return on investment.
[You will also need psychological qualities to make the whole thing work, such as being patient, disciplined, knowing the value of things, and being able to act decisively on your own reasoning (and not on the opinion of others) when the odds are in your favour]
Do the math
Why is compound interest so “magic”? The simple answer is: “Because it’s reinvested”. Compound interest is, in simple terms, interest on interest.
Here is an example. Suppose you invest £ 100. The following table shows the return you would get over different durations and at different rates of return.
Source: author’s calculations
If you invest £ 100 at 5% over 5 years you get £ 128 but if you wait 10 years that amount increases to £ 163. The longer you wait, the more you earn! Of course, it goes even higher if you can get a higher return. For example, if you can find an investment that pays 15% for 10 years, you multiply your money by a factor of 4. If you wait 20 years and earn another 15% a year (which is a lot), you get 16 times your money refunded.
20% seems like a very high unachievable return. In fact, it’s quite rare, reserved for the most talented investors, like Warren Buffett (the annual return to market value per share of Berkshire Hathaway has been 20% per year, over 55 years old…).
Two factors to remember
If you want to build wealth, you will need to start as early as possible and then focus on the best potential return you can find.
The second factor is obviously the most difficult to obtain, as it depends on careful study of key elements such as the price you pay for the assets in which you invest, and their intrinsic qualities.
For example, if you want to invest your money in stocks, you will need to select individual companies of high quality and low valuation.
High quality businesses are businesses that have a strong competitive position in their market, grow in their industry, generate high return on capital and increasing free cash flow, have strong balance sheets, and are managed by skilled people.
You can’t control the market
Cheap valuation is also not something you control. It is usually a reflection of the opinion of others, aka “Mr. Market”, who sometimes agrees to pay a lot for a business and at other times is willing to sell very cheaply (according to the real quote from Benjamin Graham in his must-read book The smart investor or these quotes from Warren Buffett in his 1987 letter to shareholders).
But if you are patient enough and know which businesses / assets you want to buy, you just have to be patient and wait for the market to give you an opportunity to buy something you like at a fair price.
Then you will just have to stick to your guns and wait for other opportunities to present themselves.