The power of compound interest

According to Investopedia, compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest”, and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.

I believe many of you know who's Albert Einstein. Many years back, he said: "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it". Even he, arguably one of the most intelligent persons in the world, recognized the importance of compound interest, so how can we ignore this wonderful concept?

There are two variables involved when you compound your wealth - number of years and interest rate / the rate at which you could grow your wealth. Longer period and higher compound rate is the best case scenario to maximize your portfolio. So who has achieved this? Must be someone who is old enough with superb investing skills right?

Yes it's him, my idol. This guy is called Warren Buffett. He is the most successful investor in the 20th century. And yes, he practices value investing which seeks to profit from discrepancy in price and value of a company. He is the third richest man in the United States due to his stake in Berkshire Hathaway, his investment vehicle and insurance company.

Source: Yahoo Finance

Buffett purchased shares in Berkshire Hathaway at an average price of US$14.86 in 1965. After 50 years (2015), one share of Berkshire Hathaway is worth approximately US$203,000! which resulted in a compounded annual growth rate of about 20%.

Invest for same 20 years, but have different investing skills

Here, investing knowledge makes a difference. Given that 5 investors invest for 20 years each, the person with the highest investing knowledge and performance (30%) will outperform the one with the worst results (10%) by such a wide margin after 20 years of investing.

Same investing skills, different compound periods

The first investor invests for only 5 years, second 10 years... fourth 20 years. Notice that the wealth gap gets wider as time goes by. Let's do some simple math.

1. 61,917 - 24,883 = US$37,034

2. 154,070 - 61,917 = US$92,153

3. 383,376 - 154,070 = US$229,306 (from above golden numbers)

So what can you observe? The difference between 1. and 2. is US$55,119 whilst the difference between 2. and 3. is US$137,153. They have the same 5-year gaps between each other but why do the discrepancies differ by so much? You might have guessed it right, it is due to 'interest on interest'!

Same investing skills, but invest later

If you delay your learning process and only started investing after 10 years, you will miss a lot of opportunities to compound your wealth when you were still young. Focus on the wealth gap after 20 years. In the 10th year, the difference might not be significant to some of you, but I believe the 20th year's gap is enough to let you see the power of compound interest.

My last words, start learning as early as possible and compound your wealth like Warren! The eighth wonder of the world only helps people with high investing knowledge and someone who doesn't spend lavishly but instead invest for the longest term possible.

If you wish to learn, in a more detailed manner, how do I analyze a company using my 5R Model and how do I calculate the intrinsic value of a company, please click here.

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