The power of compound interest. . .Even mathematicians will be amazed
RRecently, my friend Jay Monee from Budgets are Sexy wrote an article about the power of compound interest. (You may remember Jay from my interview with him about how he makes money online.)
In his article, he posed a great question: “If you start with a penny on day one and double it every day until the end of the month, how much would you have?”
Take a second to think about the answer to his question.
On the first day, we start with a penny. On the second day, it doubles to two cents, then four, eight, 16, 32 and then 64 on the seventh day. So, at the end of a week, we would still have less than a dollar – 64 cents, to be exact. It’s not all exciting.
But what do you think you would have at the end of the month?
As you know, I’m a big fan of Excel. So we can also use an excel spreadsheet to figure this out quickly.
Open Excel (or a Google spreadsheet) and find the function box. Type “=fv” for the future value, followed by an open parenthesis. In parentheses, we will enter four values:
- Interest rate: 1 – Usually we put something like 0.08 for 8%, but since we are doubling our money, the interest rate is actually 100%.
- Number of periods: 30 – Since we start on day 1 and double our money every day until day 31, we will double it 30 times.
- Payments: 0 – We don’t make any payments because we don’t add any capital.
- Current value: 0.01 – We start with just a penny, so the current value is 0.01.
Type all of this into the function box, hit enter, and what do you get?
That’s right: over $10 million. Incredible but true.
Compound interest is something we talk about a lot here, but this calculation really brings the concept to life.
Now come back down to earth. We will not double our money every day or even every year. But the power of compound interest is still amazing. To harness this power, you need three things: time, growth, and capital.
Time is the most important factor. How to use time? You start investing now.
If you start at 20, you have more time than if you start at 50. But for those who are 50 or 60 and think they’re out of time, you’re not. You are not out of time until you die. So if you say, “I’m 50. How long do I really have?” Well, you have more now than you will have when you’re 55.
The second thing you need is growth. You want as high a rate of return as possible without assuming excessive risk. We’ve talked a lot about asset allocation in our podcasts and blog posts. But, in general, know that stocks are better than bonds when it comes to long-term returns. Bonds have their place in a portfolio, but your investments in stocks or mutual funds are where the growth will occur.
Of course, you’re never going to double your pennies, like in Jay Monee’s example. But there’s a huge difference between earning 6% a year and 7% a year, or 7% and 8%. This is why the investment costs are so important. What seems like a small difference in the rate of return has a huge impact over time, given the power of compound interest.
The third thing you need is capital. You need money to invest. That’s why we talk about spending less than you earn and investing the difference. You can invest relatively small capital and, given the time and a decent return, generate a lot of money. But you need some capital to experience the power of compounding.
This is how you harness the power of compound interest. You might not get $10 million out of a single penny, but with enough time, a good growth rate, and some capital, you can build yourself a comfortable nest egg. It is probably the most powerful financial tool we will ever talk about.