The maths behind compounding
“Compound interest is the 8th wonder of the world. He who understands it, earns it. He who doesn’t, pays it”.
If you recall our article explaining interest, we concluded interest is the concept whereby you profit when you lend or invest your money. To realize this profit, through, you must wait. Sometimes you must wait years. It is precisely this aspect of investing (patience) that makes compounding so powerful. Ok, let’s stop with the abstract yada yada and explain it.
When you invest 10,000 dhs somewhere that gives you 10% interest per year, how much profit will you make at the end of the year? When I was at school, 10% of 10,000 dhs equaled 1,000 dhs.
Great. Now, how much profit will you make at the end of the following year? If you guessed 1,000 dhs again, you are guilty of underestimating and misunderstanding compounding — you are a cruel person.
How compounding is underestimated and misunderstood
Warren Buffett said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest”. Google him. Yet, still, compounding remains one of the most misunderstood forces in the world. More than love and how garlic (the stuff you put in shawarmas) is made.
Check out what happens to $100 invested at 10% interest per year, over 20 years. See how the 10% interest per year gets calculated:
Hover over each bar since 2010, and notice how your profit starts of at 10% of $100 = $10 in the first year, and then becomes 10% of $110 = $11 in the second year. Repeat this effect of earning 10% on your original investment plus the interest earned so far, and you have the definition of compounding.
Compounding is the effect of earning interest on your interest, and becomes more and more effective over time.
On the chart below, we compare what would happen to your $100 investment during the 20 years from 2010-2030 (That’s after Expo 2020, OMG, there’s life after Expo 2020!?) both with and without compounding. What do you notice?
Instead of ending up with $300 in twenty years time, you end up with $673. Crazy what compounding can do, right!? Now that you’ve understood the power of compounding, look at the graph above closely again. You should start to see, the longer you keep your investment “alive”, the further away the blue line will go from the red line.
How youthfulness gives you a crazy compounding advantage
The most valuable asset you have today, as someone who’s 18 or 19 years old, is your youth. Invest early so your money can grow over time.
The longer you stay in an investment that gives you a good interest rate, the more you will benefit from the magical power of compounding.
So why would anyone not do compounding? We are humans. And believe it or not, we sometimes mess shit up. There are ways in which you could completely destroy the power of compounding for yourself: Waste money or lose money.
If you get greedy, say you want to hit a Dubai brunch 4 times one month, and decide to withdraw the interest you earned last year to pay for this brunch overkill… then what you’d essentially have done is reset the compounding effect for this year.
The same thing happens if, instead of spending that money, you lose it due to risky or bad investments (we do this way more often than you think).
At the risk of sounding like your mother, you may feel great during the brunch, or feel like you’re adventurous when you make risky investments, but at the end of the day: you sold yourself short and handicapped your interest-earning capabilities .
Shit. Our parents were right. We do grow up and get responsible eventually.