The Compound Interest Formula And How Albert Einstein Discovered It

Compound interest is a fairly simple concept that has a huge impact on your investments. The basic rules of success for an investor are a function of your net investment return over time and the length of time you remain invested. Compound interest requires that you lock in your money for a longer period to get the most significant benefits. That being said, the market almost never returns anything near the average. Only 6 times in that span has the market returned between 5% and 10%. It usually returns much higher or much lower than 10%.

• By investing in companies that are growing, an initial investment could multiply many times.
• According to Einstein, “Compound interest is the eighth wonder of the world.
• The kind of time that young people have today to compound their investments makes old hedge fund cats salivate.
• All because you were able to make the “sacrifice” of packing your lunch.
• A force so massive actually starts from a very small place.

Before an avalanche can smash trees and break legs, it needed to become a snowball first, and a piece of snow before that. We have a 2-year-old and another baby on the way, and we love Greatest Gift’s discover section. I look forward to learning about the right financial tools to help build their future and set them up for success financially. There’s another financial concept often linked to Einstein – the rule of 72. Basically you start to earn interest on your original deposit AND you would earn interest on the interest you have just earned. It is essentially the interest that has been calculated on your initial investment and your interest you have accumulated from income from previous years.

And this is where Albert Einstein comes into play. According to Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” At first this quote might seem like a bit of an exaggeration but the math behind it shows that it is not. Now granted, 10% is a high rate of return, and not realistic to expect for most investors. Stock Market as measured by the S&P 500 Index (a mix of 500 U.S. Companies) since 1927 has been about 10% according to Investopedia.com.

It’s an easy way to calculate just how long it’s going to take for your money to double. Just take the number 72 and divide it by the interest rate you hope to earn. That number gives you the approximate number of years it will take for your investment to double. Many people will go out and max out that $12K limit that I mentioned and simply just make minimum payments on that card which are typically 3% or so. So let’s pretend that’s exactly what I did rather than correcting my actions. I have coworkers and friends that will go out to eat every single day for lunch.

By doing this, you resist being greedy when everyone else is greedy, which results in losing your shirt. What do the wealthiest and wisest investors have in common? They are always smiling, because they are making money every second of the day. The possibility of this is all due to compounding interest.

Never blindly pursue high-return investments

Some days they’ll spend $7, others it’s $20, but on average I would say it’s likely right around $12, especially if you’re sitting down somewhere. Nowadays it’s somewhat hard to go out to eat for under $10, and then landlord tax guide you can tack on a 20% tip and end up at $12 pretty quickly. Starting now is still going to give you more substantial returns than doing nothing. If you use the power of compound interest you will grow your wealth.

• His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.
• It’s the habits that you live with which define your wealth.
• The concept is that when you earn interest in X amount of time, that next time period you’re going to earn interest on the principal AND the interest that you previously earned.
• I should have STARTED with compound interest!

You may not also know that in 1921 he was awarded The Nobel Prize for Physics, an amazing achievement especially when one of his headmasters told him ‘nothing would ever come of him! R200 invested with an interest rate of 3% for 2 years (nothing is mentioned about how often the interest accrues; therefore, we assume it is annually). Interest rates are the cost of borrowing money. If you are the participant lending out the money, you receive the interest.

Albert Einstein

Those are strong words from someone who most people consider a credible source on math-type stuff. To the left are a series of example interests percentages and the calculations for how long it will take at this rate to double the investment. Trying to compare different investments with varying interest rates is hard because of the complication of the multiplication and powers. If $7,000 a year can turn into $3.0 million in 40 years, imagine what it would do in 60. It would be $21,231,575, which is of course outlandish. Nobody has that kind of money to save for their kids.

Compounding interest teaches and rewards discipline.

However, if compounding is more frequent than once per year, then the effective interest rate will be greater than 10%. The more often compounding occurs, the higher the effective interest rate. Interest only accrues on the principal amount that is invested or borrowed. Usually the interest will accrue annually, but it is important to understand the contract as the accrual may be more often than a year, such as monthly, quarterly or bi-annually.

Einstein’s 8th Wonder of the World

Let’s assume two different investors that are the exact same age. At that point, you are earning more in interest each year than you initially invested. Let’s use the example above and assume you earn 10% for 10 straight years. That’s a BIG rate of return, but it keeps the numbers round. The investment has doubled when the Value is twice the principal. Over 10 years, the total growth of the portfolio is 313%, and this could be achieved by applying a constant 12.1% interest over the 10 years.

Rather, you’re getting the option to take advantage of compounded returns, since stocks don’t pay interest like bonds and savings accounts do. But all told, compounding could really work to your benefit, especially if you give yourself a long investment window. Let’s say that you are able to squeak out a higher rate of return, because of your diligence and insight. If you earned 8% and made the same payments for 30 years, you would have grown your account to $1,622,517. If you only averaged what stocks have averaged since the 1920s (that is, 10%), your account would have grown to $2,468,473. Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns.

Albert Einstein Compound Interest Quote

To calculate the return, as before, we need to multiply out the percentages. Taking this further, how about if the interests was paid 5% every quarter? After the first year you’d have $1,215.51 (a delta of $15.51 over the yearly compound). You can make compounding interest work for you.

However, the truth is that these are both bad investments, and investment #2 is far worse that investment #1. As we reduce the time slices to be smaller and smaller, the benefit of the more rapid compounding gets smaller and smaller. To the left you can see a table of earnings in this example. It saddens me to see such disregard for the future.