Weekend Essay: Is Compound Interest Really the Eighth Wonder of the World?
I’m not used to questioning geniuses, especially in areas where I’m vulnerable like math. But to quote Dr Emmett Brown of Back to the future: âIf you think about it, you can accomplish anything. “
So this is it. Albert Einstein called compound interest the eighth wonder of the world and is said to have said: âHe who understands it, wins it; whoever doesn’t pay for it.
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These words not only carry the seriousness of Einstein’s authority, but also ring true eloquence.
The power of compound interest is so powerful that everyone you talk to in the financial world supports it. This has certainly been the case in my seven years of experience as a retired journalist. I have never met anyone who called compound interest hogwash. I have also never heard anyone make such an argument in the print or broadcast media.
The truth of compound interest is as obvious as the opinion of economists that true free trade is good for all parties. I have certainly read that this is the one point that economists of all stripes are most likely to agree on.
The reality of compound interest and true free trade in our modern world has a status similar to that of a round planet. Whatever you think, these are facts of life and affect us all like gravity. Anyone who questions them will have their eyes reserved for Flat Earthers.
But it helps to play devil’s advocate without talking about the fun of it. I believe the benefits of compound interest for borrowing a sentence from Einstein are relative. Before I tell you why I must share the journey to this perspective.
This essay was inspired by Robert Gardner who was the keynote speaker at Money Marketing Interactive London at Emirates Stadium. I tweeted this comment from him which inspired many responses.
.@robertjgardner says: ‘We have 11 million children in the UK and only 100,000 have a pension. If you invest Â£ 5 a day from birth they will have Â£ 35,000 saved out of 10. If you then stop saving, the compound interest will earn them Â£ 1million out of 60. # MMInteractive21
– Michael Klimes (@MikeKlimes_MM) 23 November 2021
Ryan Murphy, who works at the Citizens Advice Bureau, replied: âFor most families, boarding for children is not the priority. 1. Clear the debt. 2. Secure your own future – children have more time to build up their own savings. 3. Save for the child’s college fees. 4. Let the child save with higher rate relief, not your base rate. Plus, who gets paid per day? I don’t have daily cash for Â£ 5 a day. I get Â£ 0 29 days a month. I could consider saving Â£ 150 a month maybe.
Berlin writer and publisher Pete Carvill added: âA five a day will cost around Â£ 150 a month. I don’t know how many families can afford this within their budget.
Robert Gardner hit back and said: ‘The average family spends Â£ 1,300 on BOGOF offers a year that they don’t need. It’s Â£ 100 a month, which is a good start. I think a lot of families can’t start saving for their future.
All these points are valid and relate to the observation that compound interest is the best ally of your savings the earlier you start. In other words, the money you save in the first few years will give you the most bang for your buck.
This is because those savings will have the longest time to grow until you use them up and grapple with volatility along the way. But these reviews show how much a person can save, and when everything is relative.
Some may save before and more than others due to favorable circumstances and therefore compound interest is more of a friend to them. It got me asking this follow-up question on social media.
Random question to retired geeks. A tweet I made earlier today about putting money for a child in a boarding house seems to have sparked some debate about the power of the compound interest multiplier effect. My question: is compound interest overvalued?
– Michael Klimes (@MikeKlimes_MM) 23 November 2021
I believe compound interest, or the eighth wonder of the world, depends on where you stand in relation to it. My theory was reinforced by a conversation with my friend, Aegon’s pension manager, Steve Cameron.
Cameron, who is an actuary and the Ninth Wonder of the World, has an insightful view of real growth rates (investment returns minus inflation).
He says, âIn times of high interest rates it’s the eighth wonder of the world, when you have low interest rates it’s not as magical as you think.
âSo an annual interest rate of 5% for 20 years makes Â£ 100 into Â£ 265. If it’s 10% over 20 years, it becomes Â£ 673. But if the interest rates are 0.1%, then your Â£ 100 is worth Â£ 102 in 20 years.
âSo the compound is an integral part of the element of interest. Therefore, if you have to use real return to inflation, it doesn’t sound as exciting. When you project the actual growth rate, it is small and loses the marvelous. “
The table below shows the diminishing returns of compound interest when interest rates are low.
|Year||0.1% Interest rate||1% interest rate||5% Interest rate||10% interest|
|Aegon Analysis, December 2021. Interest compounded annually|
These two charts from Aegon also provide comparisons of Â£ 100 over 20 years and 40 years respectively.
There are other considerations as well: Inflation can dampen the power of compound interest by reducing purchasing power in real terms. the Bank of England Inflation Calculator lets you see how much Â£ 100 would cost in 2000, and also how much Â£ 100 in 2000 is worth today (2019).
Here’s another chart from Aegon showing the impact of the Â£ 100 failing to keep pace with 3% inflation over time at low interest rates. It shows how a small lag each year turns into a large loss over longer periods of time.
3% inflation at 0.1% interest rate means Â£ 100 will be worth Â£ 32 in today’s money terms 40 years from now, while 1% interest rate means Â£ 100 will be worth Â£ 46 in 40 years.
|Year||0.1% Interest rate||In today’s monetary terms||1% interest rate||In today’s monetary terms|
|Aegon Analysis, December 2021. Today’s monetary terms assume inflation of 3%. Interest compounded annually|
A final point in all of this was Gardner’s suggestion that pensions could be a savings vehicle for children.
Peter Carville wrote on Twitter and said: âI would say we need to rethink the idea of ââretirement a bit. I am a writer and, physically, I should be able to write until the day they take me away, pencil in hand. Someone like a firefighter may be physically able to do their job until the age of 50.
This was followed by a review from Certified Financial Planner David Hearne who said: “All the more reason not to put money in our children’s pensions, we hardly know how our own life is going to be, let alone. of our newborns. Numerous ways to save and compose money for family allowance without tying it up in a pension for 57 years.
Hearne does not dispel the power of compound interest, but argues that its power can be harnessed in a different form of a pension.
Which brings me back to my central point, your line on compound interest depends on where you relate to it in time and space. The stars really need to align for the eighth wonder of the world to materialize.