Compound Interest: The Secret of Wealth

“My wealth has come from a combination of living in America, some lucky  genes, and compound interest.” – Warren Buffet

In 2010, a former American secretary named Grace Groner died at the age of 100 years old leaving behind a fortune of $7 million. At the time of her death, everyone was surprised that a woman with such a modest lifestyle was able to accumulate such a fortune. So we investigated the origins of her wealth.

It turned out that the source of Madame Groner’s $7 million was actually… 3 Abbot Laboratories shares purchased in 1935 for the sum of 180 dollars. In 2010, Madame Groner’s initial 180 dollars had changed to $7 million. How is that possible? Through the magic of compound interest.

What is compound interest?

Compound interest is the systematic reinvestment of interest earned on its capital so that it multiplies faster. For example: Suppose you invest $1000 at the rate of 10%:

  • If you use a simple interest rate, each year you earn 10% of $1000, or $100 year 1, $100 year 2, $100 year 3 and so on.
  • If you use a compound interest rate, each year you earn 10% of the sum + the interest of the previous year, either $100 year 1, $110 year 2 (10% x (1000 + 100)), $121 year 3 (10% x (1100 + 110)), $133 year 4 (10% x (1210 + 121)) and so on.

While simple interest multiply the initial capital in a linear (so slow) way, compound interest multiplies it exponentially, because you are getting interest on interest. And even though the few dollars earned in addition to the first years may seem weak, this creates a huge snowball effect in the long term.

Here is what happens for 100 dollars invested at the rate of 10% over 50 years with a linear interest rate in blue and a compound interest rate in red:

As you can see, in the long run the difference is dizzying.

Understanding the power of compound interest

We will see a concrete example illustrating how a good understanding of compound interest can allow you to enrich yourself with much less capital and effort than the average investors.

The essential study of this graph lies in the difference between Bill and Susan: Bill saves for 30 years the total sum of $150,000. And yet he never gets to catch up with the growth rate of Susan’s savings which saved for 10 years a total of $50,000.

Once at the retirement age, Susan will have a capital of $602,070 created with her savings of $50,000 while Bill will have $540,740 with his savings of $150,000, which is the triple of Susan’s savings effort. What created this huge performance gap between Bill and Susan at the retirement age? Susan just started earlier saving $5000 per year between 25 and 35 years old. Bill started saving 10 years later, he missed 10 years of compound interest.

The main idea of this graph is not to say that if you do not start at 25 years old it is too late. The message is: Start now, because starting today will always bring you more than starting tomorrow, even if you start with little.

What if I don’t have 50 years to take advantage of compound interest?

Well it doesn’t matter, because the main thing here is to have understood the principle of compound interest. Now you know it’s better to place your money as quickly as possible, that it is better to place today than tomorrow, and even a small amount placed can bring you big in the future, as long as you act today.

Second good news, it is possible to accelerate the principle of compound interest by reinvesting its earnings more quickly (in the examples given, the earnings are reinvested only once at the end of the year). Some shares pay dividends for example quarterly and non-annually. So you can reinvest the dividends every 3 months which will speed up the pace of wealth creation.

You can also speed up the process by playing on two tables at once: the power of compound interest (by not touching your capital and reinvesting at a rising rhythm) and an interest rate that increases year by year through growing dividend. We then take advantage of a “double composition” of interests.

If you want a more concrete example of the power of this dual composition, I invite you to read this article explaining how it is possible to become an annuitant in 10 years by the stock market.