When asked what the most powerful force in the universe was, Albert Einstein said that the principle of compounding was. When applied to the world of finance, think of the awesome power of compound interest, when you are able to earn interest income on your interest income. This is how almost everyone on the Forbes 400 list made it there. Obviously, it will take a plan and a large amount of discipline to have interest income earning interest income, but with enough perseverance and time, you can make the force of compound interest work for you as well. The longer that you leave your money undisturbed to earn this interest income, the more wealthy you can become.
A couple of ways to understand tangibly the power of compound interest are: 1) Take a given amount and calculate what it would earn over time, and, 2) Relate it to a historical example.
To fulfill 1), consider the possibility of setting aside $10,000 and earning 4% interest on it over time. Once you begin to move the money made off of that interest, say after 10 years, you will now be seeing the benefits of compound interest. After 10 years, that $10,000 will grow to $14,908, giving you almost $5,000 to place in another safe and steady account. After 10 more years, that $10,000 will grow to $22,226. Meanwhile, the initial $4,908 will have grown to $7,317, etc. As you continue to re-invest your interest income from the original $10,000, all sorts of wonderful equations begin to sprout, meaning that you are actually earning approximately 5% and upwards on your money.
Even in today’s market of low-interest-bearing accounts, compound interest has an amazing power to make money for you while you do nothing and take no risks. If and when the economy improves and interest rates creep up, the effect of compound interest will increase exponentially. Again, one of the keys is having the discipline to not touch your money over a long period of time. If you do want to engage in risk-taking and investment, you can use some of the money that you make off of the top layer of compound interest.
To understand 2), consider the historical example of the Indians who sold the island of Manhattan for $24 in 1626 to a group of Pilgrims. Many financial analysts have had fun speculating what would have happened if the Native Americans had sold their beads and trinkets for $24 and invested it in an account yielding 8% compounded annual interest. The final figures are astounding!
The Native Americans would have had enough to buy back all of Manhattan today, with several trillion dollars left over for other pursuits. Here are the raw numbers: Manhattan’s land is worth about $8 trillion today. If the Native Americans had invested their $24 in an account that yielded a healthy 8% compounded interest account, they would have $345 trillion today. At lower interest rates, they still would have come out ahead, even down to 6%.
To understand just how slow our economy is today, if the Indians had only made what interest-bearing accounts are yielding in 2013, for instance, they would not have enough money to buy Manhattan, and it wouldn’t even be close. However, if and when interest rates return to near-normal levels, the example would prove true—the Native Americans would have enough interest income to buy a couple of Manhattans.
Which begs the question: which type of money manager are you? Are you close to selling or trading something that might have tremendous value down the road? Or, are you going to let the power of compound interest impact most of your money and ensure a passive income stream for years to come? The example of Manhattan stands as a lesson for all those who might make a hasty financial decision that seems wise at the time, but ends up being a huge blunder.
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