Why is compound interest so powerful? A finance student’s explanation.

Imagine you have a generous grandmother who saves you $100 every month since the day you were born. When you are 40 years old she decides to give you this money, a total of $48,000. You would be very grateful, indeed.

Now suppose you have a much less generous grandfather who decided to invest $10 for you every month since the day you were born. When you turn 40 years old your grandpa sells the investments and gives you $61,000, only having used less than $5,000 of his own money. Not only would you be grateful, but you would be in awe after seeing what his money had done. 

This growth is owed entirely to the power of compounding interest.

What Is Compound Interest?

Compound interest is a term that refers to the interest that builds on interest. Let’s break this down. When you make an investment, you hope that it will go up in value each year. Maybe you invest in real estate, dividend paying stocks, or bonds, which all provide the owner with cash-flow and additional income. Or, maybe you put your money into businesses and indexes that go up in value over time (capital gains). Either way, compound interest can play a role in each venture.

To maximize your compound interest, you would have to re-invest any income provided by your assets throughout the year so that this money can continue to work for you. What you get at the end of the year is a return on initial investment (ROI), expressed as a percent. Whatever percent gain you make each year is representative of how much your investments have grown. 

Now, if you consistently make a positive ROI each year, then this means that your investments will grow at higher and higher numbers each year because the rate of return is now compounding the gains that have already been made.

Take a look at this graph representing the story we told earlier about a grandpa who invests $10 every single month for 40 years (this graph was generated by investor.gov).

You can see that the total contributions are increasing at a linear rate because the grandfather never invested more than $10 a month. But, the total value of the investments increased greatly as the years went on.

Big Growth

Compounding interest is a driving factor in many different success stories, including people, banks, and even countries. This is because compound interest delivers big growth over time. It has proved itself to be a substantial force in the world of finance.

Warren Buffett, one of the most esteemed investors of today, once attributed his whole fortune to the power of compounding interest, and he’s not wrong. His company, Berkshire Hathaway, has compounded at a rate of 19.9% each year since he took over. If you had invested just $1 in Berkshire Hathaway stock when Buffet seized control in 1965, it would be worth over $61,000 today.

This is the reason that people refer to compound interest as the “8th Wonder of the World”, as put by Albert Einstein.

Reasons It Works

This process seems so miraculous because it is aided by the power of time. The longer an investment compounds, the more incredible the gains will be. Let’s say that our imaginary grandfather only invested money for 35 years instead of 40. Then he would have only had $36,000, which would be less than your imaginary grandmother who had saved a total of $42,000 at that time.

These long periods of time where investments are left to grow without human intervention are the backbone to American retirement plans. Most 401k plans involve investing into broad indexes that leave the employee with a sustainable and diversified portfolio built for long term growth. If you are curious to learn more about what this means, check out my earlier post, Index Funds vs. Individual Stocks. 

The S&P 500 index is the industry standard for compounding interest, averaging around 10% annualized returns. While this index is widely accessible and easy to invest in, many investors fail to meet this benchmark by picking and choosing their own securities. If you are interested in this topic, read my post How to Research Stocks: Where do I start?

The Time is Now

There is no better time to begin investing money into the market than now. This isn’t because I think that certain investments are being sold at bargain prices right now, but because you need to take advantage of all the time you have for your money to compound.

If you are a young adult or someone who is new to investing, then just start. If you don’t have a lot, that is completely okay. It’s about being consistent and building the habit. The earlier you begin your journey the more it will be pay-off in the future. 

Looking for a place to start? Read my article: Best Investing Apps for Beginners.

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This post is for educational purposes only and is not financial advice. I am not a licensed financial advisor.