“Compound interest is the eighth wonder of the world”.
So said a certain Albert Einstein, what we all know to be the scientist by definition. Don’t be scared though, it’s not about mathematical concepts or theorems, impossible to understand for normal human beings like us. It’s really not. Indeed, perhaps is one of few cases where school math becomes useful and interesting.
Compound Interest definition for dummies
Let’s start by giving a definition of what compound interest is. Compound interest is the interest that, instead of being withdrawn, it’s added to the initial capital that generated it.
This means that for the next period, the interest will be accrued on an amount made up of the initial capital plus the interest accrued in the first period. Continuing, in the third period, the interest will be accrued always on the initial capital, and both on the interest accrued during the first period and the interest accrued in the second period (which are themselves accrued on the interest of the first one).
And so on for each period that is added to the calculation. Maybe this way understanding how compound interest works can seem complicated, so let’s proceed as usual with an example to clarify the concept.
Compound interest Calculation
Let’s assume that both you and a friend have an initial capital of 10,000 $. You both choose an investment plan that generates a 10% per year, but your friend every year decides to withdraw the accrued interest.
Five year later, your friend has collected 5 times interest for 1,000 $, which added to the initial capital made a total of 15,000 $. You instead have decided to harness the power of compound interest, so every year you have reinvested the interest accrued the year before.
After the first 5 years your total capital is 16,105.10 $. Compared to your friend you’ve earned 1,105.10 $ more.
Other 5 years pass. Your friend has a total of 20,000.00 $, while you, reinvesting the interest, have reached 25,937.42 $.
Now you begin to understand the power of compound interest. After other 5 years, your friend has a total of 25,000 $, while you, beyond all expectations, doing absolutely nothing, will have total of 41,772.48 $.
We can create this major difference with an annual interest over a period of only 15 years. The chart below instead shows what would happen if we could do the same for a period of 40 years.
Not bad, isn’t it?!
Compound interest: the secret is time
In order to function and to unleash their full potential, the basic compound interest factor is time. Without the proper patience you won’t be able to reach that fundamental mathematical advantage to allow interest to mature significantly on themselves.
Now, we have made an example by taking a fixed-rate performance with annual payment. Let’s look at compound interest using instead a replication strategy, as it can be in Social Trading.
With a Social Trading strategy your account will automatically open operations of a certain weight, a weight that will be decided firstly according to the size of your initial capital.
Now, let’s say you get an average monthly return of 5%. Leaving them on the account, at some point you’ll be able to increase the weight of the operations that will be replicated, because your capital, increased due to interest, will allow a greater “firepower”.
And so on, the concept of compound interest is also repeated in the case of a trading strategy.
Now that you understand what is compound interest and the power to reinvest them, try to imagine to put together everything you’ve learned so far.
Now you know that time works in your favor, that the more you take advantage of time, the more it will pay you. Now you know that the first thing to do is to pay yourself, and you can do it by adding a fixed amount to the initial capital each month. Now you know that, in addition to your constant payments, there’s also compound interest that will rapidly increase the power of your investment machine.
So, to those who think that we can invest just by having a large capital and managing to get a large percentage of return, you can now explain that there is another way, which does not require large capital or large percentages, but just a little patience to allow time to multiply your money.