Compound Interest: The 8th wonder of the world?

My previous article outlined the need to diversify your investments and referred to compounding in passing however, I received feedback to explain compounding further. In essence, Compound interest is basically interest on interest. This should be a simple concept to understand but we often underestimate its importance and potential. In the book “The Art of Thinking Clearly” the author Rolf Dobelli writes ‘When it comes to compounding, don’t trust your intuition – you have no idea how powerful it is.’

Here’s an easy way to get your head around compounding.
Calculate 7+7+7+7+7+7 (shouldn’t be too hard… you probably got 42 without using a calculator)
Now, calculate 7×7 x 7 x 7 x 7 x 7 (unless you are mathematically gifted you would need a calculator to arrive at the answer 117,649).

Warren Buffet is one of the most successful investors and has famously said “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” Did you know he made his first investment age 11 yet most of his wealth was accumulated after he was 50. To be precise, $80.7 billion of his $81 billion net worth was accumulated after his 50th birthday. So, the moral of the story is invest young to become a millionaire!

Now that you have an idea of compounding, your next question is probably which products can earn me compound interest. Listed below are a few options to get you started (Do confirm with your provider):
• Saving accounts (these usually pay better interest rates than current accounts),
• money market accounts and certificates of deposit (CDs)
• Certain bonds such as zero coupon bonds
• Reinvest the dividends you receive on stocks/mutual funds (good if you are holding the investment long-term and you do not need the income i.e. dividend). Remember, an initial investment may multiply many times over in the course of a long time span if you have invested in companies that are growing.

Note: The flip side of Compounding is not paying your credit card bill on time. Soon enough, your initial borrowing can spiral out of control as you are being charged interest on top of interest! So if you use a credit card/store credit card make sure to pay your bills before the payment due date.

The earlier you start investing the better. Share this knowledge and encourage the younger generation on the power of compounding.