The Power of Compound Interest for Investing
What Is Compound Interest
Effects of Compound Interest
Calculating Compound Interest Using a Formula
Rule of Thumb for Compound Interest and Investing
Effects of Overtrading and Tax Have on Compound Interest
There's not a lot you learn at school that has much relevance to investing. Mostly it's about developing a base of knowledge in any particular industry and then using some good old common sense—and these are things you pick up via books, chin-wagging down the pub and experience of the wide world rather than in any classroom.
But there is one thing you should have learnt at school that's vitally important to investing, and that's compound interest.
What Is Compound Interest
Simply put, compound interest is interest paid on initial principal (original sum invested) on top accumulated interest on your investment. Interest is earned on the money invested, and on the interest already earned.
When you keep multiplying year after year, without taking anything out, after a while it really starts to mount up.
Effects of Compound Interest
If Prudence was to invest $1,000, and the compound interest is 15% per annum, in 3 years would have $1,520.88 in total. The below is how the mathematics works:
| Year 1 | Year 1 Breakdown | Year 2 | Year 2 Breakdown | Year 3 | Year 3 Breakdown | |
| Deposit | $1,000 | $0 | $0 | |||
| Interest | $150.00 | Principal x 15% Interest | $172.50 | Year 1 Interest 15% Interest | $198.38 | Year 2 Interest 15% Interest |
| Total | $1,150.00 | Principal Interest | $1,322.50 | Total from Year 1 Accumulated Interest | $1,520.88 | Total from Year 2 Accumulated Interest |
Calculating Compound Interest Using a Formula
A = P x (1 r)n
Where:
| 'A' is the end amount of your investment |
| 'n' is the number of time period in months (e.g., 2 years is 24 months) |
| 'P' is the principal, i.e. the starting amount |
| 'r' is the percentage interest rate converted to a decimal rate (e.g.;, 1% is 0.01) |
Using the above example:
A = ?
P = $1,000
r = 0.15
n = 3
We get
A = $1,000x(1 0.15)3
A = $1520.88
Rule of Thumb for Compound Interest and Investing
The way it works out, Prudence's holding doubles about every 5 years, so by the time 40 years are up, it's doubled about 8 times.
A handy rule of thumb, called the 'rule of 72', is that you can get the number of years for a doubling by dividing 72 by your growth rate.
So the real power of compound interest works when you keep going steadily upwards, year after year, without taking a backwards step.
Effects of Overtrading and Tax Have on Compound Interest
Overtrading will also slow you down because you have to give a slice of your return to the tax man each time you sell for a profit.
Yet if you just sit tight, the money you would have paid in tax remains in your portfolio earning more money. It's as if the ATO gives you an interest-free loan—and that's about the best you'll ever get out of it.
All this goes a long way to explaining Intelligent Investor's approach to investment. Our conservative style won't double your money in any one year, but it shouldn't see us taking too many backwards steps. And our long-term approach keeps trading costs low and makes good use of our loan from the tax man. We admit it can be a bit dull at times, but we'd rather have the power of compound interest working for us rather than against us.
Frequently Asked Questions about this Article…
Compound interest is the interest earned on both the initial principal and the accumulated interest from previous periods. It's crucial for investing because it allows your investment to grow exponentially over time, as you earn interest on your interest.
Compound interest can significantly increase your investment's value over time. For example, if you invest $1,000 at a 15% annual compound interest rate, in three years, your investment would grow to $1,520.88. The longer you let your investment compound, the more substantial the growth.
You can calculate compound interest using the formula A = P x (1 + r)^n, where 'A' is the end amount, 'P' is the principal, 'r' is the interest rate as a decimal, and 'n' is the number of time periods. This formula helps you determine how much your investment will grow over time.
The 'rule of 72' is a simple way to estimate how long it will take for an investment to double at a given annual interest rate. By dividing 72 by your annual growth rate, you can approximate the number of years needed for doubling. This rule highlights the power of compound interest in growing your investments.
Overtrading can reduce the benefits of compound interest because each time you sell for a profit, you incur taxes, which take away from your investment's growth. By holding onto your investments longer, you allow compound interest to work more effectively, as you avoid frequent tax deductions.
A long-term investment strategy is beneficial because it minimizes trading costs and allows compound interest to maximize your investment's growth. By avoiding frequent trades, you keep more money in your portfolio, which continues to earn interest over time.
Yes, compound interest can be a powerful tool in achieving your financial goals. By consistently investing and allowing your investments to compound over time, you can significantly increase your wealth and reach your financial objectives more efficiently.
The Intelligent Investor's approach focuses on a conservative, long-term investment strategy that leverages the power of compound interest. By minimizing trading and holding investments over time, they aim to reduce costs and let compound interest work in their favor, even if it means slower, steadier growth.
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