Albert Einstein and finance. They don’t seem to mix. Yet, he’s credited to have said, “Compound interest is the 8th wonder of the world. He who understands it… earns it. He who doesn’t… pays it.” Whether he truly said it or not, one thing’s for sure. Compound interest, and compounding in general, is a powerful tool for building wealth. Magical, in fact. And it’s available to us.
But what is compounding?
Compounding is the process of earning from your earnings. In banking terms, it’s the interest on your interest. It’s also the penalty on your penalties.
On the surface, this doesn’t seem like a big deal. But it’s actually very consequential, particularly when it’s allowed to shine in due course. Here’s an example.
Consider two options. Option 1 gives you Php1 million pesos next year. Option 2 gives you 12 monthly payments starting at Php1,000 in month 1, receiving double the amount for every succeeding month — Php2,000 in month 2, Php4,000 in month 3, and so on. By month 3, you’d have a total of Php7,000 (Php1,000 + Php2,000 + Php4,000).
Which option looks appealing?
Option 1 instinctively looks nice. That’s Php1 million without complications. But when we crunch the numbers, Option 2 is hands down the better option. By month 10 you’d have Php1.023 million. By month 12, you would’ve had a total of Php4.095 million!
(This example was first published in the blog post Finance for People Who Hate Math.)
Now, doubling doesn’t happen in the real world. But the example highlights the importance of compounding — it’s how Php1,000 beats Php1 million.
It also shows how the effect of compounding increases over time. There is a snowball effect, which we can take advantage of by investing early. It’s how accumulating millions (even billions) is possible.
Warren Buffett is worth billions of dollars and is one of the richest men in the world. He made his fortune by investing wisely with a buy-and-hold strategy. Interestingly, a large portion of his net worth was accumulated after he turned 50 years old. He’s also quoted to have said that an index fund of $10,000 invested in 1942, when he bought his first stock, would’ve been worth $51 million in 2018 (now worth around $71 million). When asked why not everybody does that, he answered “because nobody wants to get rich slowly.”
Compounding is also important because it’s a phenomenon that can be used to disprove a lot of myths in finance. For instance, the 8k rule in stock market trading, says not to invest when the amount is less than Php8,000. While relevant for active traders, it isn’t practical for beginners — a majority of beginners are either apprehensive to invest Php8,000 in something they don’t fully understand, or they end up spending the money.
Fortunately, compounding provides some compelling proof against the 8k rule. Here’s the gist: Although the 8k rule lowers your costs, the compounded returns from investing early can more than offset these additional costs.
The message is clear. Start early and take advantage of the power of compounding. Start now.
Compounding is key to generating more wealth when used wisely — when it’s allowed to compound over long time horizons. Maybe invest for your retirement or a planned expenditure over the next 5 to 10 years? How you use it matters less than just actually using it. Start early, start now.
Bio: Dan Dima-ala is a 2-time real estate board exam top-notcher, real estate investor, entrepreneur, and former corporate finance professional. He has a degree in economics & finance and is a certified Accounting & Finance Mentor for GoNegosyo. As a financial freedom advocate, Dan shares his unique insights at freedom locker PH