The people I respect most, both in finance and in other aspects of life, are those who are smart enough to make small changes that end up in big results. Perhaps it’s human nature to wait for the big change, the earth-shaking tremour. Yet, real advances are made slowly, carefully and using our greatest advantage- time- to it’s full advantage. Look at the Higgs Boson (or God Particle). Higgs suggested it’s existence in 1964, after years of research. CERN confirmed it’s existence last week.
To my mind, compound interest is the God particle of personal finance, the missing link in our standard model. Spending less than we earn, and saving the difference is the framework of stable personal finance but it is compound interest that makes the money. So here is how to make it work for you and your finances.
What Is Compound Interest?
Like all truly beautiful things in this world, compound interest is very simple. Say you invested $100 for a couple of years. You had an interest rate of 1%. At the end of the first year, you would have $101. Great. It gets better. At the end of the second year, you have $101.01. Compound interest reinvests, so your principle is larger and garners more interest. Times those figures by ten. Times them by fifty. Over the course of a couple of years, as your principle grows, so does the amount it earns. Obviously, inflation and fees detract from some of your interest, but the basic equation of compound interest shows that if you invest $5,000 tomorrow at 10%, in 50 years time it will be worth well over half a million dollars.
Using Compound Interest For Wealth Creation
This is essentially why the rich continue to get wealthier; the greater your capital, the more interest you earn on it. But it’s not a principle isolated to the wealthy alone, we have many opportunities to take advantage of compound interest. Our superannuation is the perfect example. The earlier we start (and I would suggest making voluntary contributions as well as your employer contributions), the more time we allow compound interest to work its magic.
Early Investment Is Key To Compound Interest
For myself (and I am speaking solely of my own personal finance situation here and not suggesting this in any way as advice), compound interest is the bolster I need for my finances. Say I invest $5,000 tomorrow. I invest it in a relatively balanced portfolio and intend to leave it for the next 50 years. Research has shown that the market- if given enough time- generally increases between 5-10%. Yes, there is a possibility I could lose money. And yes, inflation will eat away at my gains. But while $5,000 is a significant amount of money, it’s not a massive risk in the long scheme of things. A couple of months wage out of a 50 year working life, and the possible benefits, using compound interest and time to my advantage, are fantastic.
This is why experts suggest starting to save and invest young. The greater your capital, the more it will earn and if, like me, you weren’t born with a silver spoon, time is the key element. The longer you give your investment to mature, the lower the risk and the greater the benefit.