The Power of Compound Interest for Investing
A breakdown of the power of letting money grow on its own.
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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.
