Compound Interest Explained. The 8th Wonder Of The World. (2024)

There is a fable that has been told many times the world over about the miracle of compound interest. It is called ‘the wheat and chessboard problem’ (sometimes told in terms of rice grains instead of wheat). It goes like this…

Years ago, an Indian King spent hours every day honing his true passion – chess. He enjoyed challenging others who dared play against him and boasted his flawless winning record. One day, a visiting sage passed through the kingdom, and naturally, the king challenged him to a game. The king told the sage he would wager any reward the sage desired.

The sage pondered for a moment. He requested that if he won, the king would pay him in wheat – the quantity of which being the king would put one grain of wheat on the chessboard’s first square, and every square after that, double the previous one (one on the first, two on the second, four on the third, eight on the fourth, and so on).

The king, having an overabundance of wheat, smugly accepted the humble request. They played, and lo and behold, the sage won.

True to his word, the king ordered his treasurer to pay the agreed-upon sum.

A week later, the sage returned to the king and asked why he had stopped receiving his reward. Outraged, the king summoned the treasurer, who explained that the sum could not be paid – that by the time they had paid half of the chessboard, the remittance was more than the entire kingdom possessed.

As the king began to realize what the reward entailed, the sage told him that he did not have to pay it all upfront; the king could pay him back over time. And that’s exactly what the king did, and the sage lived out the rest of his life as the wealthiest man in the world.

It’s difficult to comprehend how such a simple concept could bankrupt an entire kingdom, but the math doesn’t lie. By the 15th square, the king would owe the sage 16,384 grains of wheat. By the 25th square, he would owe the sage 16,777,216 grains. And by the 64th and final square, he would owe him more than 18 quintillion wheat grains.

This fable illustrates the concept of compound interest or reinvesting your returns to accumulate additional interest on your past investment. It is a powerful force. ‘Interest on interest,’ as it is sometimes called, can make you the wealthiest person in the world, and it can bankrupt kingdoms. Albert Einstein once called it the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn’t pays for it.”

Unfortunately, compound interest can also work against you, particularly with loans. If you struggle to pay off debt on time, banks may charge you a late fee, which may take a hit on your finances but can be recoverable. However, if you struggle to meet multiple payments, the interest on your loan(s) will compound. You’ll owe more, it will likely reduce your credit score, and you may even have to forfeit collateral or other assets to meet the repayment.

Compound interest is the true secret to success in the stock market. Let’s say, at 25 years old, Jane invests $10,000 in a fund earning an annual rate of 5%. She leaves it untouched for 40 years; she doesn’t add more to it than reinvesting the interest payments, nor does she take out any of it. By the time she’s 65 years old, that original $10,000 investment is now worth $70,399.88. That’s right! With an annual interest of 5%, Jane ended up with more than seven times the amount of her original investment.

On the other hand, simple interest is a fixed amount and only adds interest to the principal payment (i.e., in the example above, adding $500 each year). Because compound interest earns interest on interest, it takes the interest from the principal amount and adds it to all the interest earned that has accumulated over time. So, after the first year, Jane earns $500 (5% of $10,000), but in the second year, she earns $525 (5% of $10,500), and $551.25 after the third year (5% of $11,025), and so on. So, if Jane’s savings vehicle earned 5% as simple interest, she would have $30,000, but because it compounds, she’s gaining an extra $40,399.89.

The effect of compound interest becomes even more powerful over extended periods as the amount of earned interest grows. Therefore, it is so important for individuals to start investing for their retirement early. It can be challenging to rationalize setting money aside for the delayed gratification of using it in retirement, especially when someone is just entering the workforce and now has money to spend. For example, if Jane decided she would set that money aside just five years later when she turned 30, at age 65, the value of her investment would be $55,160.15. She lost out on more than $15,000 because she decided to wait just five more years.

Now, these are oversimplified scenarios. Some years, her investment may go up; some years, it may go down, depending on the market. Some years, she may be down on her luck and need to take money out of her investments. Some years, she may get a bonus or a raise and contribute more.

In the long run, understanding tried and true concepts like compound interest and sticking with them will be your ally as you travel along your financial journey. Wealth is built over long periods, being disciplined with your investing, not chasing trends in the market, and not trying to time your investments. For this reason, we recommend finding an investment program that works for you, given your goals and circ*mstances, trusting the process, and not getting too caught up in the markets’ inevitable short-term ups and downs.

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Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.

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