Richer, Smarter, And Better With Compound Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Albert Einstein once called compound interest the most powerful force in the universe.
When applied to your finances, compound interest will certainly make you rich. But most people don’t know it can also make you smarter, and more connected with the people you love, and more comfortable in business.
First, here’s an overview of what compound interest is and how it works.
Compound Interest In Finance
Simple Interest Vs. Compound Interest
When it comes to investing, simple interest is just interest gained only on a principal investment. So you’re earning a set amount on a set amount.
For example, if you were to invest $1,000 at 7% annual simple interest for five years, you would yield $350 after year five ($70 per year x 5 years).
Compound interest earns interest not only on your principal investment but on the interest you gain in the meantime.
So, if you invest $1,000 and get a 7% annual interest rate, after one year, you have $1,070. After year two, though, you’ve not compounded $1,000. You’ve compounded the $1,070. After five years, your yield is $402.55 versus the $350 yield with simple interest.
Compound at 7% annually for 20 years, and you’ll turn $1,000 into $3,870 - almost quadrupling your money.
Here’s a brilliant image for compound interest from the brilliant designer, Jack Butcher of Visualize Value:
Design by Jack Butcher of Visualize Value
Here’s the most important thing to remember about compound interest: The greatest gains come at the END of the compounding period.
Warren Buffett is worth about $86 billion. The majority of his wealth (99.7% of it) was created after his 52nd birthday.
That’s the power of compound interest - it takes a while to get going, but over 20-30 years, it will change your life.
Compound Interest In Everyday Life
Compound interest works for more than just your money.
Remember, Einstein didn’t call it the most powerful force for wealth creation. He called it the most powerful force in the whole universe. Here’s how you can leverage compound interest in other parts of your life.
Compounding Knowledge.
This is one of my favorite quotes from Charlie Munger:
Spend each day trying to be a little wiser than you were when you woke up. Day by day, and at the end of the day - if you live long enough - like most people, you will get out of life what you deserve.
If you give yourself the goal of getting just 1% wiser every day - you’re smarter when you go to bed than you were when you woke up - what does that look like over a full year?
Writer James Clear has the answer, and it’s insane:
Photo from JamesClear.com
You are a whopping 37 times better at the end of the year than when you started. This is why being a life-long learner is such an advantage. Imagine doing this year after year for decades.
Remember, the greatest gains come at the END of the compounding period, so keep going.
Compounding Ideas.
Compounding ideas by writing works the same way. Here’s what I wrote in an article called How To Be An Idea Compounder.
An idea compounder is someone who layers ideas on top of each other to find new ideas and ways to apply them. They understand that: 1 idea + 1 idea ≠ 2 ideas. It equals 3+ ideas.
Over the very long term, the results are staggering. You’ll end up building an ever-changing idea framework that’s capable of handling and making sense of any idea you throw at it.
All of the ideas you collect will compound on each other to build a strong frame - a lattice of mental models, as Charlie Munger would call it. The more ideas you can add and compound, the stronger your frame will get and the faster you can move towards your goals.
Check out the whole article for some examples of idea compounding.
If you’re ever in awe of people like Warren Buffett or Charlie Munger when they speak, remember they’ve been compounding ideas for a lifetime.
Compounding Personal and Business Relationships.
Compound interest works for professional and personal relationships, too. Here’s Naval Ravikant in a podcast episode explaining this:
Long-term games are good not just for compound interest, they’re also good for trust…When you have been doing business with somebody, you’ve been friends with somebody for ten years, twenty years, thirty years, it just gets better and better because you trust them so easily. The friction goes down, you can do bigger, and bigger things together…Whether it’s goodwill, or love, or relationships, or money.
I’ve personally found this to be true. My wife and I have been together for more than six years. Each day that we commit to each other, our relationship gets stronger. The friction decreases. We can aim for bigger things together than we would have aimed for on our own. Our relationship is compounding over time.
The same goes for relationships with the people you do business with. The older the relationship, the less friction there is to build bigger and bigger things. The downside to this is that if you switch industries, you get reset to zero. You have to start compounding again with new people from scratch.
And like all compounding, the greatest returns are on the backend of the relationship period. This means you should be doing bigger and bigger things with the same people as you get older. And it’ll be fun because you already know and like working with them!
You Must Hang Around Long Enough To Reap the Rewards.
The hardest part about compounding anything, whether it’s your money, your relationships, or your health, is accepting that the payoff comes at the end. You have to compound for a long time at the beginning for what seems like inconsequential results.
Unfortunately, many people DO quit there - right before they begin to see the results of their hard work take off.
So, do not quit. If you are working on the right thing or with the right people and compounding consistently, all you need is patience. The greatest gains come at the END.
Keep going.
Special thanks to Emma Cranston for her help in creating this article.