Monday, September 16, 2013

Einstein's Eighth Wonder


One of Albert Einstein's famous quotes dealt with finance, not physics.  He said, "Compound Interest is the eighth wonder of the world.  He who understands it, earns it...he who doesn't...pays it."

Compound interest is interest on a debt which includes any previously unpaid interest as principal.  In other words, interest on interest.  The classic example is the credit card.  Assume you have a balance of $1,000 on your card which accrues interest at 12% per annum.  Therefore, the simple interest on the debt is $120 per year or $10 per month.  If you make a payment of $5 one month, the unpaid $5 of accrued interest becomes part of the principal the next month.  Next month, your new balance is $1,005 on which the interest rate is again calculated.  On a larger scale, think of America's national debt.  One of its bonds comes due.  To raise the cash to pay off the bond, the federal government issues a new bond which includes the principal of the old bond plus the accrued interest.  

Compounding also works in calculating returns on investments using the mathematical Rule of 72.  It states that you can determine your annual rate of return on an investment if you know how many years it takes for the investment to double.  If you divide the number 72 by the number of years, the result is the rate of return.  Conversely, if you know your rate of return on the investment, you can determine how long it will take for your investment to double.  Using the same formula, you divide 72 by your rate of return and the result is the approximate number of years it will take for the investment to increase 100%.

All Wall Street professionals advise people to start investing as early as possible, length of time being one of the factors in growing a portfolio.  The sooner an individual starts investing, the longer for the portfolio to grow.  One simple example (and a suggestion to parents and grandparents).  Assume you open an Individual Retirement Account for your child with $2,000 per year starting when he or she is 14 years old.  You invest an additional $2,000 each year for four years for a total of $8,000.  Neither you nor your child make any further deposits into the account.  Assume that amount is invested in an S&P 500 Index fund, which has, despite yearly ups and downs, grown at an average of 8% per annum over the last several decades.  If the return is 8% per annum, then the Rule of 72 states that the amount will double every nine years.  At that rate of return, the $8,000 will have doubled by the time he or she reaches 27.  The $16,000 will become $32,000 by his or her 36th birthday.  When your adult child celebrates his or her 45th birthday, the IRA will be worth $64,000.  That amount will have grown to $128,000 by age 54.  By 65, with one more double, the IRA will be worth $256,000.  And this is without putting one more penny into the account!  With continued $2,000 investments over and above the initial $8,000 (that's his or her job), the IRA should grow to well over $1 million dollars by the time that former 14 year old reaches retirement.

Compounding is an investor's best friend and a debtor's worst enemy.

Comments are always welcome.

No comments:

Post a Comment