This week I want to dive into a few aspects of wealth to spur some thought on how you can build it, so my first question is – do you believe in magic? Well, there’s a kind of magic that works wonders in the world of finance, and it’s called the magic of compounding interest. Understanding the idea of compounding interest can be your key to financial success, whether you’re investing in stocks, saving for retirement, or setting money aside for your child’s schooling. I want to kick start the week by taking you on a tour of the fascinating world of compounding interest in this post, dissecting it into manageable chunks, giving you practical examples, and equipping you with (at least the tip of the iceberg) information you need to make your money work for you. That is ultimately the key to financial freedom.
The Compounding Interest Spell
Let’s first clarify the meaning of the term “compound(ing) interest.” Compounding interest is fundamentally the interest that is paid on both the initial amount of money (the main) and the interest that has accrued over time. The mysterious turn? Over time, it keeps expanding rapidly, turning a little investment into a sizeable fortune.
The formula for compounding interest is the following:
A = P(1 + r/n)^(nt)
While each represents either total amount of money, principal, annual interest rate, etc. It’s kind of pointless for nearly all of us because you’ll find easy to use calculators just about anywhere. So rather than getting bogged down in mathematical jargon, let me use a practical example to demonstrate the power of compounding. (And its not the first time I talk about it)
Example 1: Mary’s Savings And Magic Of Compounding Interest
Mary is a dedicated saver. She makes the decision to deposit €10,000 in a savings account with a 5% yearly interest rate that is compounded every year. After ten years, we can determine her whole savings using the compounding interest formula: A = 10,000(1 + 0.05/1)^(1*10) – while I do find understanding the underlying concept important, you can just as easily use any online calculator. It’s quicker, easier, and reliable. Either way, based on this (and I’ve double checked using the calculator), Mary would turn her €10,000 initial investment, thanks to the miracle of compounding interest, to over €16,000 in just ten years.
Now to some that may not seem like much after 10 years, however, give it some thought and read my other article here and I would even recommend reading this one. You see the power of compounding interest is time. For most of us I think in our heads we say – “I want to double my money.”
Well there is an easy way to look at that in regard to time and compounding interest.
The Rule Of 72
To determine how long it will take for your money to double through compounding interest, I use a straightforward rule of thumb called “The Rule of 72”. To calculate the anticipated number of years it will take for your money to double, divide 72 by the yearly interest rate.
Let’s take Mary again from above. If she put €50,000 into an investment with a 6% yearly interest-bearing return. Using the Rule of 72 you can easily calculate:
Years to Double = 72 / 6 = 12 years
Her €50K investment will have increased to €100,000 in around 12 years. Why do I mention this. Well, again, it’s about the power of time and how, when it comes to investing and compounding interest, time is your ally.
I hope that was an easy introduction into the topic. However, now I want to dive into a few areas I think are relevant as well, without going into incredible detail, but just enough to intrigue you to look into this strategy of investing.
We are not taught in school how to go about with money – in other words what it is, what to do with it, how to use it, etc. You may have heard me or read here as well when I say that the school system is broken. We are conditioned to run a rat race. Depending where you are in life you may think, it’s all cool but let me break it down with a visual example. Imagine John and I, two friends who are both 25 years old (whoa) and have the same aspiration to retire and to live well in our retirement at 65. While John decides to wait until he is 35 to start investing the same amount with the same return, I begin putting €200 per month in a retirement account with a 7% annual return.
Now watch how our investment journey develops – here is our baseline:
- Starts at 25
- Invests €200/month
- 7% annual return
- Starts at 35
- Invests €200/month
- 7% annual return
John’s account would only be about €257,669 at age 65, whereas mine would have risen to about €542,264. I had a significant edge due to my early start; in comparison to John, my retirement money has nearly doubled. This illustrates a very simple lesson: the earlier you start investing, the more time your money has to grow. It seems so logical, however, the majority, and I mean majority of people out there have no idea.
Now you’re like great and thanks for sharing Hermann. But it’s all useless to me, because I don’t have anywhere to put my money (if you have any left over at all – and that is for a different post), as I don’t know where. Again, this is not financial advice. I am not going to tell you what to do. I’m just spurring thought on what you could do, which brings me to:
Compounding in Action
1. The Stock Market
One of the most well-liked methods to profit from compounding interest is stock market investing and it is probably the most well known methods. If you look at charts, the stock market has traditionally produced outstanding long-term returns, and compounding these returns makes them even more alluring. Again, just like our example above with Mary, if you invest €10,000 in a portfolio of diversified stocks with a 7% average annual return – we can quickly do the math and see that the amount you would have – if you left your money alone for 30 years, is roughly €43,677.45. Thanks to the power of compounding interest, that is more than four times your initial investment. And again I reiterate, patience and consistency are crucial. Reinvest your dividends, hold onto your investments, and let time do its magic.
Note: what stocks to hold is a totally different question.
2. Real Estate Trick
Another option for compounding interest is real estate. When you invest in rental homes, you can watch your equity increase as the value of the properties rises. Let’s say you take out a mortgage to pay €200,000 for a rental property. Your tenants pay off your mortgage as the value of the property rises over time. Your property is fully paid off and worth €400,000 after 20 years (that is what I consider a “normal” timeline – and not all the hocus pocus going on as of recently). The equity you’ve built can be considered the result of compounding interest in the real estate market.
Note: real estate has its own unique set of dangers and obstacles, despite the fact that it may be a miraculous investment.
In recent years, the world of finance has witnessed the rise of cryptocurrency, a digital asset that operates on decentralized blockchain technology. While I am not goiong to get into the nitty gritty of it here, cryptocurrencies have their own version of compounding interest through the possibility of significant price increase as well as interest returns. And I know that to most people it may appear like they are worlds apart from traditional assets – however, I am a fond believer of the potential this technology has.
While investing into crypto is one thing, many assets in the crypto world offer hansom returns and literally let your money work for you. One such place I can recommend is Nexo.
While beauty lies in the eye of the beholder, Art in recent years (whether digital in the form of NFTs) or actualy paintings has become more of an asset that my generation and the next seem to appreciate not in regard to the finesse and style, but in terms of investments. Now is there really a compounding aspect to it aside from potential appreciation in value. Well, not really. But I still wanted to list it as a potential thought.
Those are 4 areas to think about.
The Monthly Investment Habit
Compounding’s magic can be used to your advantage by consistently adding to your investments, whether they are in retirement accounts, savings accounts, brokerage accounts, or cryptocurrency holdings. And I think I have given plenty of examples above. The main lesson here is that consistency, whether in traditional investing or the digital space, may over time transform tiny, regular payments into significant wealth. It’s just a matter of patience, and strategy. Now I know the main problem these days is inflation. ANd the numbers being presented by governments are absolute BS. So here a few of my thoughts on beating inflation with compounding interest.
In essence, inflation is the silent enemy of your money. Over time, it reduces the purchase value of your money. Compounding interest, on the other hand, can assist you in fending against inflation in both conventional assets and cryptocurrency. Now these days, it is hard to beat 5%, 7% or even 12% inflation. Some had it worse this year – Google the top countries for 2023:
- Sri Lanka
Ethiopia had 33%. No guess what the others had? Puh. But again, make your money work for you. The system is broken, but just having it sit at home or on a bank account is probably one of the worst things you can do. Hence, invest regularly. Invest smart. Invest in things you understand. Putting all of your financial eggs in one basket can be dangerous. Whether you’re investing conventionally or in cryptocurrencies, diversifying your investments can reduce the impact of under performing assets. And that, just like the market at the moment is a risk. Here are my 8 tips to think about:
- Set Clear Financial Goals: Determine your savings or investment goals, whether they be for retirement, a home, your child’s education, or anything else.
- Establish a Budget: Take into account both your traditional and online investment options as well as your present financial condition to create a budget that will allow you to routinely save or invest.
- Choose Your Investments: Decide which types of investments best suit your objectives, level of risk tolerance, and time horizon. Stocks, bonds, mutual funds, real estate, tax-favored accounts, and cryptocurrency assets may all fall under this category.
- Consistency Is Vital: Commit to making regular investments in both traditional and digital assets. Magical compounding increases the more you continuously invest.
- Diversify Your Portfolio: Regardless of asset type, avoid placing all of your money into one single investment. The possibility of long-term success grows thanks to diversification, which also helps disperse risk.
- Automate Your Contributions: To guarantee consistency, you might want to set up automatic transfers to all of your investing accounts, including the ones designated for cryptocurrencies.
- Keep informed: Monitor your assets, keep abreast of market trends, and alter your plan as needed, especially when dealing with the always changing world of cryptocurrencies.
- Consult a Financial Advisor: A financial advisor who can offer advice on both conventional and cryptocurrency investments should be consulted if you’re unclear of where to begin or need help with complicated investments.
Whether you decide to invest in conventional financial instruments or venture into the virtual worlds of cryptocurrencies, the magic of compounding interest is a financial spell that may completely alter your financial future. It’s a force that rewards persistence, strategic preparation, and patience, giving you the chance to reach your financial objectives, guard your capital against inflation, and ensure a pleasant retirement (at least that is my hope). Whether you want to invest conventionally or in cryptocurrencies, keep in mind that the earlier you begin, the more intense the enchantment becomes. With that being said, take the plunge, and let compounding interest become your financial ally as you pursue wealth.
Make it happen.
- Investopedia. (n.d.). Compound Interest. https://www.investopedia.com/terms/c/compoundinterest.asp
- The Balance. (n.d.). The Rule of 72. https://www.thebalance.com/the-rule-of-72-2385903
- CNBC. (2023). Here’s how much you need to invest each month to be a millionaire by age 65. https://www.cnbc.com/2023/02/21/heres-how-much-you-need-to-invest-each-month-to-be-a-millionaire-by-age-65.html