Lesson 3: The Importance of Compounding
Most of you are familiar with the concept of compound interest, but it is worth repeating because of its importance.
There are two main ways to grow your wealth;
- In a linear, straight-line by earning simple interest or,
- In a geometric fashion known as compounding.
Let us assume we want to make $100,000 by investing the $20,000 we have saved up over our lifetime and we can choose between two investments;
Both earn 10% per year, but one earns 10% per year based on the initial $20,000 we invested (Linear/Simple Interest), and the other earns 10% per year on the balance of our account at the beginning of each year (Geometric/Compound interest).
In the race to $100,000, which one wins?
When you see it in the graph above, the answer is relatively straightforward.
By earning 10% interest on our initial investment each year – Simple Interest – we can only earn $2,000 of interest per year regardless of the balance at the beginning of each year, meaning that by Year 10, we are not even halfway to our goal.
If, on the other hand, we earn 10% per year on the balance at the beginning of each year – compound interest – then we are effectively earning interest on the interest we made the previous year. The amount of interest we earn each year grows, and by year 17, we will have reached our target.
So, whatever you invest in, make sure it is compounding!
Examples of simple interest:
- The money you lend to a friend – your friend pays you back a certain amount of interest at agreed-upon intervals based on the money you lent them.
- Interestingly, interest earned on a 10-year US government bond is simple interest. Similarly, corporate debt is often simple interest.
Examples of compounding interest:
- Specific money market instruments that pay interest on your balance at the beginning of each period.
- Investing in your own growing start-up business.
- Investing in growing businesses listed on a stock exchange provided you invest in that business for the long term.