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The eight wonder of the world: compound interest

Reading time: 4-7 minutes (1.239 words)

Investing is all about compound interest. Albert Einstein once said:

Penke

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it.”

It really starts to get interesting when you look at compound interest. Compound interest means you reinvest the interest you received on your investment. An example:

If you invest $10.000 with an annual gain of 10% you will have $11.000 at the end of the first year. If you take your profits of $1000 out you will have $10.000 in assets and $1000 in profits. If you take out $1000 for the next ten years (assuming you will gain 10% each year) you will have:

  • $10.000 starting capital
  • $10.000 in cash (profit)

When using compound interest, you'll reinvest the profits. The first year you will earn $1000 in profits. You now have $11.000 in assets. In the second year you will not gain $1000 but $1100. If you re invest the gains for the next ten years (assuming you will gain 10% each year) you will have:

Year Initial investment Total value
0 $10.000 $10.000
1 $10.000 $11.000
2 $11.000 $12.100
3 $12.100 $13.310
4 $13.310 $14.641
5 $14.641 $16.105
6 $16.105 $17.715
7 $17.751 $19.487
8 $19.487 $21.435
9 $21.435 $23.579
10 $23.579 $25.937

After ten years you will have:

  •  A total $25.937 in assets from which $15.937 in profits ($25,937 - $10,000 initial investment)

     

The magic of compound interest is that you gain profits over the interest you gained in the previous year. Meaning your gains will grow exponentially when time passes. That’s why you should think about money you invest as something you can't touch for the next ten or twenty years. You can’t do this with money you need right now or in the short future. If you are in for the fast money and using the profits for other things you will not benefit from compound interest.

The above example is based on an initial investment of $10.000. Now imagine what will happen when you not only reinvest the interest you receive but also invest an extra $500 each month for the next 10 years:

  • Initial investment: $10.000
  • Monthly investment: $500
  • Total investment after 10 years: $70.000
  • Total value after ten years with 10% interest: $121.561,97
  • Total gain: $51.561,97

Compound interest is one of the biggest factors of solid returns in the long term. Even if you only have small amounts of money to invest each month, in the long run (ten or twenty years) compound interest will add up. But this only works when you don’t take out any profits. As you can imagine, many people will take profits at some point. Because they need the money or they just want to buy something like a new car. This destroys the compound interest in the long run. That’s why it’s very important to determine what kind of trader you want to be and what exactly your goals are. I discuss this in “what kind of investor you want to be

Why compound interest only really works with large amounts of money

Although compound interest definitely works when investing small amounts of money. It takes many decades to live from just the interest. If you invest $450 each month you’ll be a millionaire in 40 years. But keep in mind that million does not have the same value vs a million right now due to inflation.

The only way to speed up this process is by adding more money each month and cutting down on your expenses. If you have a high paid job, cut all your costs and desires then you can become financially independent (living off the interest) in 15-20 years time. But that also means you can’t spend money on things you want like a big house or a sports car. If you can only invest small amounts each month, it will take many decades of compound interest to add up. But what if you start with $500,000 right away? With an annual average return of 7% that means you make $35,000 on average each year. Most people don’t have $500,000 lying around. But that is because they work for someone else. Working for someone else is very ineffective because you are stuck with two very important variables that determine how much money you can earn:

  • Time
  • Hourly wage

You can only work X amount of hours a day. And your job will only pay a maximum amount of hourly wage. For example, is it possible to earn $500 an hour in your current job field? Probably not. You are simply swapping your free time for money.

But if you create a business selling products or services, the above variables suddenly change exponentially:

  • Time now works for you. You can sell products and services through a website 24/7. Even while you are sleeping.
  • The amount of money you earn is based on the amount of products you can sell. If your product or service can be used by millions, you can potentially earn multiple millions.

That means that once you have completed your product, people can buy it and you can do whatever you want. Your website is online 24/7, you can go for a swim or a bike ride while your customers are ordering your product. Not only does this give you the most important asset in the entire world: time. You are also earning way more money than you ever can working for somebody else.

On the flipside, creating a business is not easy and will cost you a huge amount of time before you actually have a working website and product. Most people don’t want to spend the time and effort and just work for someone else. Which is totally fine. The only downside is you’ll be working your entire life to pay off your debts. But businesses can also fail. There are no guarantees in business. 

The point is, if you are in it for the money and maybe want to become a millionaire, it would be better to start a business instead of working for forty years on a job you hate and hope compound interest makes you a millionaire. If you even live that long to enjoy the money because if you are in your forties already, what are you gonna do with a million if you are eighty?

This is all part of your financial plan. Everybody can be a millionaire if they really want to. But you have to put in the work. It’s totally fine if you work for someone else, but if you don’t have a high paying job it will take some decades to build up a decent amount of money. If you don’t want to wait that long and enjoy the money when you are young, maybe starting a business is something for you. 

Most people find investing for the long term very tedious because it simply takes a lot of time to create wealth. So they start day trading because that is where the fast money is. Not realising day trading is very risky and requires a tremendous amount of time to learn. Starting a business is also something that requires a tremendous amount of time and there are no guarantees. So what is left? The lottery! People want to skip the hard work but still want to be a millionaire. The lottery is exactly made for those kinds of people. They expect to be a millionaire without doing anything. That is simply not how it works. The chance to become a millionaire by buying a lottery ticket is literally zero.

Everybody dreams of millions. The question is, does it stay a dream or do you want to make it a reality?

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