Albert Einstein has been quoted as saying that Compound Interest is the most powerful force in the universe. When interest is added to an initial investment, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding (i.e. the interest is compounded).
So for example, a portfolio of £100 that compounds by 10 percent a year rises to £110 in year one to £121 in year two, £133 in year 3 and so on.
There is a story about an Emperor of China who was so excited about the game of chess that he offered the inventor of the game one wish. The inventor replied that he wanted one grain of rice on the first square of the chess board, two grains on the second square, four on the third and so on through the 64th square. The unwitting emperor agreed to the modest request. But two to the 64th power is 18 million trillion grains of rice - more than enough to cover the entire surface of the earth. The Emperor, realizing that he had been duped, had the inventor of the game beheaded.
I don’t know any investments where you can guarantee to double your money every year, let alone every day, but the principal holds true even at modest rates of growth of say 6% or 7% per year.
The key to getting this principal to work well for you as an investor is to start early and understand the powerful effect of time. The best example I like to use is of a young associate aged 26 who invests the maximum of £600pm (£7,200 a year) into his Stocks and Shares ISA. They decide to invest for 10 years, investing a total of £72,000 and then leave the money to accumulate. Our second dentist decides to wait until they own a practice and is earning more money and starts investing £7,200 a year from aged 36 to age 65 – so this dentist has invested three times as much - a total of £216,000.
Assuming they both achieve a return of 7% (tax efficiently as it’s in an ISA) who do you think has made the most money by age 65? Is it the young associate investing £72,000 or the principal investing a total of £216,000?
As this article is about the power of compound interest you have probably realised that the younger associate will have more money, accumulating £810,263 by age 65 – 11% more than the principal who’s only got £727,726.
Remember this principal works the other way round with debt, so unless you pay off your credit cards and unsecured debt, the interest will accumulate on the interest making the bank money rather than you.
So start investing as soon as you can, and get your money working hard for you!