According to legend, Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it.”
Although controversy swirls over whether Einstein actually uttered or wrote those words, there can be no doubt that compound interest is one of the most powerful – and least understood – concepts in the world of investing. Why so powerful? Because understanding how compound interest works and employing it to your advantage can make you money. A lot of it over time. Credit union executives understand the concept of compound interest, but many of your CU members may not. Why? I’m stumped. Maybe because it’s not typically taught in school. Maybe because the subject of our own money seems to be a semi-taboo topic of discussion in our society. Maybe because it’s not sexy. Regardless, it can’t be the result of complexity – understanding compound interest is not exactly akin to understanding the theory of relativity. But, fear not. Here’s a plain-English primer on compound interest and a way to explain to your members how they can harness it over time to boost their investments, whether in a savings account, 401(k), SEP, IRA, college fund or any other investment.
Savings with Interest Re-invested doesn’t Grow in a Straight Line; it Grows Exponentially
Many non-financial people think savings with re-invested interest grows in a straight line – an arithmetic progression. As credit union executives know, it doesn’t; it grows in an increasingly upward-sloping curve – a geometric progression. Compound interest, in the context of investing, is interest added to principal, which then itself begins to make its own interest from then on. Earning interest on interest. Very interesting. It’s the interest payments generated from the principal of an investment account that is added back into the principal so that the previous interest now also begins to earn interest itself. Like a snowball rolling down a hill. As the snowball (the principal) rolls, it picks up more snow (the interest), which make the snowball larger, which causes the snowball to pick up more snow each time it rolls over. Before you know it, you’ve got a great big snowball. And you’re happy as a kid! This analogy is so apt, it was used in the name of a book about Warren Buffett, the greatest investor of our time – perhaps of any time. The book is called The Snowball: Warren Buffett and the Business of Life. Buffett is a buy-and-hold investor who generally prefers to buy stocks (often with the “float” or premium payments from his insurance company holdings) and keep them for a long time while their price appreciates over time and the dividends (e.g., interest) generated from them is plowed back into the stock.
Fortunately, your members don’t have to be Warren Buffett to take advantage of the snowballing effect of compound interest. And they don’t have to study all the funky formulas on Wikipedia’s “Compound Interest” page to reap the rewards of this slow and silent financial wonder. Just make a little snowball by contributing to a 401(k), SEP, IRA or kid’s college fund and keep adding to it automatically every two or four weeks with payroll or bank account deductions. Then roll it down a hill (on slope that they feel comfortable with and that is right for them) by investing in reputable mutual funds, stocks and/or bonds that they understand. They shouldn’t fling it down a steep, rocky, double black diamond expert run unless they know the risks and are prepared to live with the possibility of their snowball breaking asunder into a tree or boulder after growing fast and large. On the other hand, they should be wary of being too conservative by picking an extremely conservative bunny hill that may result in a very slow rolling and small snowball, which may not create as much compounding over time. And regardless of the incline, they should resist the temptation to stop the snowball from rolling temporarily while they dig a chunk out of it to buy a fancy new car or take a European vacation. Although expensive splurges are fun, their poor snowball’s growth will be stunted from such meddling because its mass and momentum will be impaired. Instead, suggest they consider setting up a separate “fun” account at the CU with the idea that they’ll invade it without guilt when the spirit to splurge (within reason) moves them in the future.
The key to investing and reaping the rewards of compound interest is to let it work for investors by giving it lots of time and opportunity. And (this is the hardest part) to really know yourself; your true risk tolerance, your financial goals, your overall financial situation in life, and your time horizon so that when your investment snowball creaks to a gentle stop, it will be large enough to meet your goals. If members do it right, as the snowball grows large, their principal contributions will pale in comparison to the compounding effect. With time, the snowball’s growth may be powered more by compounding than their contributions. Then, at the bottom of the hill they can dig in, have a big snowball fight and still have some left over to bequeath a few snowballs to their kids and grandchildren.
All because of the eighth wonder of the world.