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Compound Interest Effect

“Compound Interest is the eighth wonder of the world” - Albert Einstein

Source of content: https://www.clearwealthasset.com/einsteins-8th-wonder-of-the-world/

Overview

Definition
“The magic penny” - a thought experiment
A realistic example for the Compound Interest Effect
The Compound Effect for personal growth

Definition

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Compound Interest is interest that is earned not only on the original amount of money you put in an account, but also on the interest that money earns over time. As time goes by, the interest you earn gets added to your original principal, which means that you earn even more interest in the following periods. This can create a snowball effect, where your money grows at an increasing rate over time.

Source content: https://www.investopedia.com/terms/c/compoundinterest.asp

“The magic penny” - a thought experiment

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Imagine the following case: Either you get a suitcase filled with three million $ in cash right now, or you choose to get one penny, which doubles every day for 30 days. What option would you choose?

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In the diagram below the red line shows how the doubling of the one penny develops and the yellow line represents the suitcase with the 3 million cash. From the initial penny, at the second day you have two pennies, the next day you have four, then eight and so on. But compared to 3 million dollar that’s nothing. Even after three weeks you cant see anything is happening at the red line, although the penny already doubled up to about 10.000 $. But in the following days the red line really goes through the roof! Suddenly the doubling of the penny has an enormous effect. After 30 days the penny doubled up to over 5 million dollar.

Source of image: Own illustration [Messerer, Leonhard]

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A doubling per day would correspond to an interest rate of 100% per day. So basically the magic penny is an easy example for how the Compound Interest Effect works.

Source of content: https://www.forbes.com/sites/shaharziv/2019/07/30/can-you-correctly-answer-the-magical-penny-question/?sh=61c442091a64

A realistic example for the Compound Interest Effect

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For the following case we assume that a person invests 10.000 $ at an interest rate of 5% per year. In the diagram below you can see how the invested money develops over time. After the first year you have the 10.000 $ plus the interest, which adds up to 10.500 $. After the second year, you have what you had after the first year plus the interest. But this time you receive the 5% interest not on the initial 10.000 $, but on the 10.500 $. As you can see from the orange bars, the interest grows bigger and bigger from year to year. And that‘s what makes Compound Interest so powerful: at some point the effect really kicks in and the capital increases enormously. After 25 years you get nearly 35.000 $.

Source of content: https://www.finanzfluss.de/rechner/zinseszinsrechner/

The Compound Effect for personal growth

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The Compound Effect does not only work for interests. Also in fields not related to money, small actions can make a huge difference if pursued over a long period of time. This is what James Clear, the author of the bestseller „Atomic Habits“ calls „The power of tiny gains“. If you improve a certain skill one percent a day, for a whole year, you will be about 37 times better at it, than the year ago. That’s why you should never underestimate small, seemingly insignificant actions. The Compound Effect ensures you will be reaping huge rewards from persistently pursuing them.

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Because you cannot improve something until you measure it, it is really important to track the activity you want to become better in. You can, for example, write down in an habbit-tracker calendar, what you have done exactly to improve a certain skill.

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An investment in self-improvement can help you improve your life and also bring you success in your investments. To educate yourself on how the stock market works, what alternative forms of investments exist and to keep track of your spendings, for example, will make a huge difference, if you stay disciplined and learn consistently over a long period of time. Therefore the Compound Effect not only multiplies money but also skills and knowledge.

Source of content: James Clear (2019): Atomic habits; Hardy, D. (2011): The Compound Effect; Baid G. (2020): The Joys of Compounding; https://medium.com@sarahcythe-compound-effect-by-darren-hardy-book-notes-cf01799e2cc3; https://www.youtube.com/watch?v=oZIvEr-Kkx8