Snowball Effect- The Wonder of Compound Interest

Compound interest is such an impressive phenomenon that Albert Einstein is believed to have named it the eighth wonder of the world. I recall an occasion that really cemented the power of compound interest while I was a kid. My dad posed a riddle when I was 8 years old giving me two hypothetical offers:

1. $100,000 cash

-OR-

1. A single penny doubled every single day for the period of one month

While the $100k cash offer seemed like a no brainer at the time, he explained how the penny doubled every day for a period of thirty days would lead to over $10 million dollars: as shown in the equation below:

Value= $0.01 (2^x)

Where x represents the number of days the penny is doubled. This example provided an early lesson on the true magic of compound interest and exponential growth possible for money.  Please realize that if someone offers you an investment that doubles every day, you should run the other direction or also embrace your long lost aunt who just happened to be a queen in Zaire and is looking to contact you.

Also, my sister gifted a book to me when I was 16, $traight Talk on Investing, written by Vanguard’s CEO. This book showed many charts and graphics indicating the power of compound interest and the huge benefit of time. I don’t remember the specific examples provided but they were very demonstrative of the benefit provided by investing early, and convinced me to start funding a Roth IRA with my earnings from my high school summer job. Now, any nerd can quickly fire up Excel and run some hypothetical situations showing the power of compound interest and soon get pretty fired up.  Consider the example below showing the importance of investing early as it examines a $10,000 savings invested and earning 7% interest over various timeframes:

Amazingly, the original $10k sum soars to nearly $300k after 50 years’ time, nearly 30 times the original investment amount. Looking at the pattern, you might notice that the sum nearly doubles from years 0-10 from $10k up to $20k and then again from 10-20 years from $20k to $39k. This aligns with a rule of thumb known as the Rule of 72. The Rule of 72 is a handy guideline for figuring the exponential growth of an investment.

RULE OF 72-    Number of Years For Investment to Double= 72/ % Interest Rate received. In our example above with 7% interest rate, every 10.28 years the interest rate will double. The power of compound interest explains how the greatest American investor today, Warren Buffet, was able to become one of the world’s richest men with a net worth ranging between $50-$60 Billion dollars. Warren made successful investments averaging over 20% interest for his career. At an interest rate of 24%, the investments will double every 3 years! Not quite as impressive as our magical doubling penny above, but pretty staggering still and he was able to harness the power of compound interest into billions over shrewd investments during his 60+ year investing career.  Conversely, this implies the importance of avoiding credit card debt often in the high teens to upper twenty % as financing frivolous items on the plastic will have the amount of interest paid surpassing the actual cost of the item due to compounding.

Another powerful historical lesson comes from the sale of Manhattan. In 1626, American Indians sold Manhattan Island for a collection of beads and trinkets worth $24. What a rip-off by the American settlers, right? The land value of all of Manhattan is estimated at over $800 BILLION dollars as of 2006. Well, let’s look at the potential investment value if the Indians had liquidated the beads and invested the proceeds elsewhere at our 7% interest rate (note, the US historical S&P stock market interest rate has been over 10% annually in its history). The Indian group would be laughing hysterically at the silly Americans who bought Manhattan as their fortune from the Beads of $24 invested over the 380 year period would result in over $3.5 TRILLION, leaving them enough to buy Manhattan back with $2.7 Trillion left to spare!

The more time available for the investment, the more impressive the sum will grow with interest as the interest earned one year grows and earns interest of its own. In the context of money savings, the money one saves and accumulates for investment “goes to work” by producing more money. This can be considered the “snowball effect” whereby the small snowball rolls down the hill and gains more and more snow until the mammoth rolling snowball is many times larger than the original snowball. I am seeking to embrace the snowball effect by standing atop the mountain and giving my small little snowball (savings and investments early in life) a good shove down the mountain to enjoy the mammoth snowball at the bottom of the hill (growth of investments into later years). It sure beats being someone racking up massive credit card debt early in life akin to waiting at the bottom of the sledding hill for the mammoth snowball to pulverize you with its massive girth of accumulated interest.