The Miracle of Compound Interest

Apparently, Albert Einstein once called compound interest “the greatest mathematical discovery of all time”.  I am sure you will have heard of this term.   The question is why and how powerful is it over the long term?

Take a look at the table below:

This table shows the accumulation of a starting initial capital of $10,000 over each month, for the next 120 months (10 years). 

Column 1: 0.25% per month interest rate

• 0.25% per month is equal to 3.04% per annum.
• Almost similar to our F.D. rate in Malaysia.
• $10,000 capital grows to $10,304 after 12 months.
• After 10 years, it grows to $13,494, or 35% returns after 10 years.
• Unfortunately, this doesn't keep pace with "real life" inflation (not the government statistics).
• When the interest rate is small, compound interest has little impact, and requires a much longer period to work miracles.

Column 2: 0.75% per month interest rate

• 0.75% per month is equal to 9.38% per annum.
• After 10 years, $10,000 grows to $24,514, or 145% returns.
• In Malaysia, there are very few passive investments for the lay person to earn this kind of returns over the next 10 years.  An example may be a property investment in a high demand area with good long term capital appreciation coupled with good rental income, after subtracting associated costs and expenses.   However, this type of property will cost much more than US$10,000.   It is not easy to earn 145% returns over the next 10 years today.
• In the U.S., this type of returns are available for example, to passive U.S. indexed stock investors or Dividend Growth Investors who are in the game for the very long term.  For example, the returns on U.S. indices including dividends after taxes are typically around this 9%-10% per annum returns over the past 50 years.
• Note 0.75% = 3 x 0.25%.  However, 145% >> 3 x 35% (= 105%).   The excess returns after 10 years of 40% (= 145% - 105%) is due to the miracle of compound interest.
• In short, higher interest rate and longer investment time increases the miracle of compound interest.

Columns 3 to 5: 1.5% to 2.5% per month interest rate

• This is the "Warren Buffett" / Super Investor type of returns consistently over the past 5 to 6 decades.   In his early years, it was closer to 2.5% per month (or 34% annual returns), in his later years, it gradually reduced to 2% and 1.5% per month as his capital grew bigger and bigger causing a slight drag over time.  Still, Warren Buffet is truly a great living example of how Compound Interest has allowed him to accumulate massive wealth over long periods of time.
• In his early years and most of his career, Warren Buffett did not employ leverage.  However, traders who employs leverage can enhance on this returns.   Hence, this area of returns (1.5% to 2.5% per month, or 19.6% to 34.5% per annum returns) is usually the Minimum target returns for the very few successful long term traders that employs leverage, either from Margins, high leverage instruments (like Options, Futures, CFD, Forex, etc.), High Turnover (instead of passive investment), or other forms of leverage.
• Note that at 2.5% per month returns, a starting $10,000 investment will grow to $193,581 or 1,836% after 10 years.   Whilst 2.5% per month is 10 times F.D. rate of 0.25% per month, the impact after 10 years of 1,836% is much larger than 10 times 34%.  This is the power of compound interest.   Extend that beyond 10 years (like 20, 30, 50 years) and you'll discover an even greater power.  This is how Warren Buffett became the world's richest men over decades.   By investing in a safe and predictable instruments that generates consistent 1.5% to 2.5% per month (equivalent, in Intrinsic Values), over decades.

Columns 5 to 8:  3% to 5% per month interest rate

• These columns may appear like a "dream" for most investors and traders. 
• Yet, in any one month, many investors and traders are able to achieve a one-time 5% per month returns. 
• However, the critical difference is sustainability.   When we extend the period to 12 months, 24 months, 36 months, 60 months and 120 months, 99.9% of investors and traders drops off very, very quickly  
• Nearly all traders and investors are unable to sustain this type of returns over 10 year periods.   The few that do are the Market Wizards, the Super traders in the world that eventually become billionaires.
• However, when one's capital is still in the small stage (e.g. US$10,000 and a small portion of one's net worth), it is possible to adopt a more aggressive trading strategy that aims to achieve this type of returns relatively safely.
• If you are successful to achieve 5% per month returns, you could turn $10,000 into $17,959 or achieve nearly 80% returns per annum.   Compound that for 10 years consistently, and your $10,000 can turn into $3.5 million, or nearly 350 times, or 35,000%!  Contrast the 34% return from F.D. after 10 years.  Isn't this a miracle, transforming $10,000 into $3.5 million to transform your life?
• Whilst 1,000 readers reading this may understand the mathematics, unfortunately, there are extremely few (less than a handful) real life traders who are able to achieve this consistently over a 10 year period.   I don't know yet of any Market Masters in this region who have obtained a 10 year audited real life account that showed this type of returns, but many do show great progress to meet and exceed this target over a much shorter period than 10 years.

Summary and Conclusion
If one is serious to grow his/her net worth over the long term, here are some takeaways:

1. Start Now.

• The more time you have, the greater the miracle.
• Start today, because every day that passes is an opportunity lost.
• Start when you baby is born, or even better, before the baby is born, so that s/he has a lifetime to capitalize on this miracle.  Grandparents may consider helping their grandchildren.
• Like Warren Buffett and every one else, we all have the same 12 months in a year.   Don't squander each month.  Make each month counts.

2. Learn to improve the rate of returns.

• If you have the habit of putting monies in a savings account that earns extremely low interest, start by moving them to F.D. for monies you don't expect to touch immediately.   The difference between 1% and 3% makes a large difference over your lifetime - much more than you can imagine.
• If you have been stocking huge amounts of monies in F.D.s, consider paying off your debts and mortgages first.  If you are debt free, consider owning a second investment property or other assets that appreciates in value over time that has a long term proven returns exceeding F.D.s. 
• Again, even 1% difference in yields, if they are reliably proven to be superior over the long term, makes huge differences to your future net worth.

3. Try to avoid negative returns.

• Someone who achieves 2.5% per month consistently will end up doing better than another trader that achieves +10% in Month 1, -5% in Month 2, +10% in Month 3, -5% in Month 4, and so on.   Surprised?   The 2.5% consistent achiever will grow $10,000 into $13,449.  Whereas someone who achieves +10%, -5%, +10%, -5%, etc. will only grow $10,000 into $13,022, or 4% less.  
• This is because negative 5% returns requires more than +5% returns to break even.
• It is always better to avoid losses, especially large losses, as it requires more than the same magnitude of returns to break even.

4. Be patient and stay disciplined to stay the course

• Most professionals are aware of compound interest and the miracles.   Much have been written about it.  Yet, so few actually practiced it year in year out over very long periods of time.   Majority are still in debts after decades and not yet financially free.  Why is this?
• Perhaps it starts with the real life observation that "knowledge alone is not enough to accumulate wealth over the long term".  If knowledge alone is enough, the world's richest would be the smartest people on earth, and yet, we know this is not necessarily true.
• Knowledge + Action helps to get a good, start, but also doesn't appear enough.  We all know people who has the knowledge and has started to act on it, but somehow, life has a way of moving them "off course", and they are not successful after decades.
• Knowledge + Action to Start + Action to Stay Disciplined and stay on the course seems to be a better way.   The question is how to stay disciplined?  Every day we have life priorities.  Compound interest is a very important topic, but is usually not urgent once we have started to take action.  A minimum level of discipline, persistence, commitment is usually required.  It doesn't guarantee success, but without it, it assures failure.
• There are many ways to stay disciplined.  For example:
• Seek like-minded friends and family with similar goals to constantly remind each other the importance of staying disciplined. 
• Read articles, books, blogs, on similar themes from time to time to stay disciplined. 
• Post reminders (like the table above) on your private wall at home to remind you regularly of the power of compound interest. 
• Tabulate your Net Worth each month or each quarter to just see the progress, to remind you how you are doing. 
• We all need some reminders some times to help us stay the course, when we have the knowledge and have started to take actions.

5. Compound Interest rewards you exponentially more the longer you stay true to the course

• Look at the 2.5% per month column.
• After 5 years, this turned $10,000 into $43,998, or nearly $34k gain.
• The next 5 years turned $43,998 into $193,581, or nearly $150k gain!  $150k gain is much, much bigger than the first 5 years gain of $34k gain.
• Just imagine how large the following 5 years gain will be like!  Do the maths yourself, and it will blow your mind away.

I sincerely hope you are successful in engaging the power of compound interest to transform your life over the very long term.   Let's plant the seed and consistently grow the tree, to create miracles in our lives in the future!