Albert Einstein on compound interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Compound interest is the most powerful force in the universe.
Compound interest is the greatest mathematical discovery of all time”
So, Albert Einstein thinks this is the eighth wonder of the world, huh. Must be pretty amazing. We should dive into this and take a look.
What is compound interest you ask? Well…..Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. In English that means that it can be thought of as interest on interest. So if you have a $10 balance with a 10% compounded interest at the end of that period you would have $11. So the next time it is calculated it will be based on the $11, not the initial $10. Which means that the next balance after the interest is compounded would be $12.1!! That means that your money will grow at an exponentially greater rate than just simple interest, which is calculated solely on the principle. Pretty amazing stuff really.
Here is another chart to help illustrate the point I am trying to make. Notice that with an initial deposit and no other contributions how much this will grow.
The point I am trying to make with these illustrations is the importance of savings as well as finding a place to put your money to watch it grow like this. This is the path to wealth. There are no get rich quick schemes out there that will safely grow your money like this. Sure, there are extremely risky investments that you might hit it big with but really it is like playing the lottery or hitting it big at a casino. They call it gambling and that is no way to grow your wealth.
In this case sure and steady win the race. People like Warren Buffett, Charlie Munger, Peter Lynch and others did not make their riches overnight. It was using the magic of compound interest over the course of many years.
Warren Buffett has been investing for over 50 years but he didn’t reach his level of wealth until the last 20 years or so. And this has been because of the incredible thing that is compounding his returns.
How does this grow wealth?
Compounding has it’s greatest impact in the stock market. This is where the greatest accumulation of wealth occurs without having to reinvent the wheel or come up with the next great widget.
Sounds great but how does this work exactly? By investing in stocks that continue to grow over time and if they have dividends, so much the better. I will delve into the nitty gritty of this going forward. Just know that as you grow in your knowledge of the stock market and how it works it will all start to make more sense.
Dividends in their simplest form are a method of cash payment back to their investors. It is the company’s way of giving back a portion of the money the company earns to the people that invest in their company.
As the company grows, typically it’s dividends grow as well. Companies that distribute dividends are some the more stable investments that you can put your money into. I am always looking for companies that pay out dividends as a way to help my savings grow.
Keep in mind as we start to discuss anything in regards to the stock market that there are no absolutes. Things constantly change and evolve as businesses continue their journey. The reason I mention this is that there are no guarantees and no sure things in the stock market.
So how do dividends increase my savings? Simply by having that money added to your pot of money that is growing, it just helps add more fuel to the fire for compounding interest to work its magic.
To clarify we are talking about stocks that distribute dividends. Stocks that do not have dividends also contribute to compound interest. But their contribution is based on the growth of the price of the stock. This continues to grow over time as well. The reason I look for dividend paying stocks is that they help increase the growth from the payouts as well as the growth of the stock. This is an added bonus for investing or putting my money in this company.
To put this in terms related to money. Imagine buying a stock for $100. At the end of the year the price has grown $10. The next year it is worth $110. And so on. Now plug dividends into the equation. Your stock price has grown $10 for the year as well as adding another $5 in dividends. At the end of the year you have $115 to start the next cycle of compounding. So you can see how adding dividends into the equation can help your investment grow that much faster.
Next time we are going to look deeper into how this works to compound your growth with stocks as well as mutual funds. And what are the differences between how these work for you. I challenge you to start looking at the stock market for some stocks you might be interested in and to investigate whether or not these are dividend payers or not. Don’t worry about finding the perfect company; we will start diving into that soon.
Until next time take care and let me know your thoughts, ideas and questions.