Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.
-- Charlie Munger
When I first learnt about investing, I was told about the power of compound interest.
You may have been shown a chart something like this to explain it:
| $10,000 @ | 3% | 6% | 12% |
|---|---|---|---|
| 12 | $14,257.61 | $20,121.96 | $38,959.76 |
| 24 | $20,327.94 | $40,489.35 | $151,786.29 |
| 36 | $28,982.78 | $81,472.52 | $591,355.74 |
| 48 | $41,322.52 | $163,938.72 | $2,303,907.76 |
-- Source of calculations: The Calculator Site: Compound Interest Calculator
What was immediately obvious is that I wanted to be invested at 12% for 48 years!
Would you be surprised to learn that this kind of chart hides almost as much as it reveals about compound interest?
I'm going to reveal some big surprises, but first, let's dig into some of the ins and outs of compound interest.
Photo by Kim Gorga on Unsplash
Simple and Compound Interest and ROI
To start with, we need to untangle three different terms:
- Simple interest
- Compound interest
- Return on investment (ROI)
Let's start with the last one first.
Return on investment is the amount returned from an investment.
For example, if we invest $100,000 in the house, and later we sell it for $150,000, our ROI is $50,000.
Simple interest, on an investment, is very similar to ROI, in the sense that it's the simple percentage of return on your investment.
Taking the example of the house again, the return on investment of $50,000 divided by the initial investment of $100,000 provides a simple interest rate of 0.5 or 50%.
Simple interest can also be annualized, and this often eye-opening.
For example, if the house is owned for one year, the interest rate is 50% divided by 1, or 50%.
If, however, the house is owned for 50 years, the annualized interest rate is 1%.
Which means that your money grew by only 1% every year.
Lastly, we get to compound interest.
With compound interest the seed money (a.k.a principle) earns interest.
Then that interest gets reinvested and the principal and interest both earn interest.
Most people have experienced compound interest in a bank account.
The daily or monthly interest goes directly into the account.
And the next month both the principle and the interest earn interest.
If most people have a bank account and can see compound interest in action, why doesn't everyone understand it?
Sadly, because the amount of interest (and, therefore, interest on interest) is so small that it's imperceptible to most people.
Compound interest is really powerful because, given enough time, the growth becomes exponential.
Exponential growth always starts very small, but the longer it grows the larger the increases are.
Looking back at the chart above, it's the last 12 years where the most growth happens.
Photo by Icons8 team on Unsplash
Glittering Gold
It's been said, "All that glitters is not gold".
So too, not every investment compounds.
Think back to the house we bought for $100,000.
Imagine that we hold the house for 5 years during a rising market.
Every year we have the property appraised and every year we are told that the value of the house has gone up by 5%.
At the end of the 5 years, we go to The Calculator Site: Compound Interest Calculator and expect to sell the house for $127,628.16.
Except, that in the 5th year, the market hits a major bump and nobody will offer us more than $99,000!
What happened to our compound interest?
While the value of the property seemed to have increased, there was no interest that was generated by the property.
Since there was no interest, the interest was never re-invested to earn its own interest.
And without interest being re-invested, compounding can never occur.
"The difficulty of getting it…"
The Charlie Munger quote at the top of this post points to a great truth: getting compound interest is not easy!
As amateur investors, we imagine that our investments are going to compound.
We convince ourselves that we need only hold on to assets in order to become rich.
Time will be our friend!
Yet, as amateur investors, we are drawn to investments that do not compound!
Investments that grow (or shrink) in value do so much faster, and therefore look like much better investments.
We ask questions like, "Why would I invest in a 5% bond when I might make 20% or more in cryptocurrency?"
A Generational Travesty
There is a whole generation of people retiring right (about 1,000 people/day here in Canada).
Many of these people were sold investing as a way of making their retirement comfortable.
Naturally, as they were building their portfolio, they opened their quarterly or annual mutual fund reports and wanted to see large percentage increases.
To achieve large increases, they consistently chose funds that were heavily skewed toward value appreciation, since bonds or income-producing stocks grow more slowly.
Their advisors often encouraged this behaviour, not understanding themselves the difference between simple and compound interest.
Since little or no income was produced there was little or nothing to reinvest and ultimately little or no compounding.
Over the course 10 years, this doesn't seem like such a big deal.
Over the course of 20+ years, however, the effects of compounding can become much larger than simple interest.
Far too many of those retiring today are turning to their investment accounts only to find that they don't have the of millions of dollars they expected.
Their disillusionment and bitterness often come out as "Mutual funds don't work, and I'm the proof".
The next generation sees this disillusionment and without understanding what it was about the funds that didn't work, echoes the idea.
A deeper look shows instead that simple interest will never perform like compound interest.
This is not the end of the story, nor a recommendation to only buy bonds.
As the first table shows, getting 3%, even compounded over 48 years, provides a miserable return.
The "holy grail" is really to be able to get interest that compounds at 8% or more annually for as long as possible.
As Mr. Munger points out, it's much harder to achieve than most people are willing to admit.