Albert Einstein once noted that the most powerful force in the universe was the principle of compounding interest. In investing, this is the most powerful tool to transform your life.
Compounding interest means that you begin to earn interest on your previously earned interest income. This results in your money growing at an ever-accelerating rate.
Compounding Interest Puzzle
There is a special offer at a garden shop. They are selling super grass attached to sod that doubles in size every day.
Peter is excited about the special offer and figures that his garden is big enough that if he buys one patch it will cover his garden in ten days because each day it doubles in size.
Peter decides to speed up the process and buy two patches of super grass. How many days will it now take for the super grass to cover the whole garden?
Think about this puzzle, and try to solve it on your own before checking the solution below. The answer may not be as simple as it initially seems!
Solution
The puzzle states that the grass doubles in size every day (for 10 days), so you can calculate the total surface area with 2^10 = 2,048.
Now, by doubling the amount of grass patches we can create a new equation and solve for our unknown variable!
2 * 2^x = 2,048
Divide by 2 on both sides to get a new equation: 2^x = 1,024. Solve for x, and you will discover that “x” = 9! Yes, this sounds crazy, but by doubling the amount of patches you only actually decrease the growing time by 1 day!
Many people oversimplify this puzzle, and they assume that adding an additional patch would cut the growing time in half to 5 days!
Unfortunately, this would be oversimplification, and you would be thinking in a linear fashion, rather than exponentially.
How This Relates to Compounding Interest
2^9 = 1,024 but 2^10 = 2,048! This means that in JUST ONE DAY you have doubled the amount of growth from the previous 9 days combined.
The formula for the future value (FV) of an investment is FV = PV (1 + r)^n.
The present value of a dollar is what a dollar earned in the future is worth in today’s money, where r is the interest rate the money earns, and n is the number of periods until it’s received.
Clearly, the biggest factor for increasing the future value of your investment is to increase your investment time length (n).
Many people do not have the ability to comprehend exponential growth because humans don’t process large numbers well.
This video below is super interesting and talks about how humans think linearly, but investing is exponential.
Doubling Your Money in the Stock Market
Your investment portfolio should double roughly every 10 years with a 7% return! Assume you start investing $10,000 at age 20, this $10,000 portfolio could double 7 times by your 90th birthday!
30 = $20,000
40 = $40,000
50 = $80,000
60 = $160,000
70 = $320,000
80 = $640,000
90 = $1,280,000
Your money has grown from $10,000 to $1.28 million without ever adding another dime! Now that you have seen the power of compounding interest, what should you do about it?
1. Begin Investing As Soon As You Can!
If you begin investing at a young age, history tells us that you will end up with far more than those who wait to start.
Compounding returns are extremely powerful over the long run, and the earlier you get started the greater your chance is to take advantage of this.
This is the power of the time value of money, and regular investments in an investment portfolio or a retirement account can lead to huge compounding benefits.
2. Enroll In Your Company 401(k)
Arielle O’Shea tells a funny story from her first day in a Forbes Article, “New Grads, Don’t Make These 401(k) Mistakes“.
“Day One at your first job typically goes a little something like this: Show up; feel relieved you are dressed appropriately; attempt to hide that relief; attend orientation; marvel at the concept of paid vacation days; hide in the bathroom to avoid the 401(k) election form.
At that point, if you’re anything like 22-year-old me, you call a lifeline. I dialed my brother, who gave me a brief 401(k) rundown, asked if the company would match my contributions — they would — and told me to sign up.
He probably used the words “free money,” as people tend to when describing the benefits of a 401(k) match.
They do that because it is actually free money: When your company matches your contributions, they’re compensating you in addition to your salary.
Your own contribution, on the other hand, is pulled out of your paycheck, and needless to say, that was a sticking point for me.
I would have gotten behind the idea of free money I could pocket immediately, but free money I wouldn’t see for 45 years didn’t excite me, especially when it meant taking home less money every month. I opted out”.
3. Pay Yourself First
Coming directly from Get Rich Slowly, “To pay yourself first means simply this: Before you pay your bills, before you buy groceries, before you do anything else, set aside a portion of your income to save.
Put the money into your 401(k), your Roth IRA, or your savings account. The first bill you pay each month should be to yourself. This habit, developed early, can help you build tremendous wealth.”
When asked how to pay yourself, “The best way to develop a saving a habit is to make the process as painless as possible.
Make it automatic. Make it invisible. If you arrange to have the money taken from your paycheck before you receive it, you’ll never know it’s missing.
Part of your savings plan will probably include retirement, but you should also save for intermediate goals too, such as buying a house, paying for a honeymoon, or purchasing a new car.”
Finally, why to pay yourself first, “If you’re just getting started in the Real World, saving may seem impossible.
You have rent, a car payment, groceries, and maybe student loans. Sure, you’d like to save, but there’s just no money left at the end of the month.
And that’s the problem: Most people save what’s left over — left over after bills and after discretionary spending.
But if you don’t develop the saving habit now, there are always going to be reasons to delay: you need dental work, you want to go to Mexico with your friends, you aren’t making enough to pay your bills.”
Compounding Interest
Many people do not have the ability to comprehend exponential growth because humans don’t process large numbers well.
It is not completely unreasonable for your investment portfolio to develop every 7-10 years! Begin tapping into compounding interest immediately for building a lifetime of wealth.
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