Compound interest is something that has been around for a very long time. It is fundamentally important and powerful. Unfortunately, not too many people get excited about it.
So, what is compound interest?
According ASIC’s MoneySmart website: “Compound interest is like double chocolate topping for your savings. You earn interest on the money you deposit, and on the interest you have already earned – so you earn interest on interest.”
Compound interest can be used as a wealth creation tool.
Our brains are not naturally wired to think about our wealth creation, investments and superannuation in such a way.
For example, let’s assume you made an investment in a business, or a property or the share market:
- Let’s assume that it has doubled in value over the course of 7 years. Does that sound appealing?
- Or what if we said that it has doubled in value over the course of 5 years. Does this sound more appealing?
How about we rephrase the above two examples in terms of compound interest equivalent. Here we go…
- Let’s assume that you made a compound return of 10% per annum over the past 7 years. Does this have the same appeal as the above?
- Or what about this? You made a compound return of 14% per annum over the past 5 years.
Whilst 10% and 14% are by no means small numbers, it does not have the same appeal for most people and it is less straightforward to grasp.
An easy and quick way for you to roughly reconcile between doubling your money and compound interest is to use the rule of 69.
Simply divide 69 by the number of years you want your investment to double in value to get the required annual compound interest rate or vice versa. Following this rule, in our example, dividing 69 by 7 is approximately 10% and dividing 69 by 5 is approximately 14%.
So what does that mean in practice? With the rule of 69 you can easily see the appeal of compound return and put it in perspective.
Note that returns are seldom stable and linear year on year and therefore it is important to look at the big picture and think long-term.
See Goggling article wealth creation via long-term investments for more details and remember that short-term investment fluctuations are part of long-term investing strategy.
As of the date of writing this article, there are basic superannuation funds that have done a compound return of about 10% per annum over the past 7 years. Or a simple index investment that is readily available and easily accessible has done a compound return of about 18% per annum over the past 5 years.
Arguably of course, there are similar stories with real estate and small businesses. After all, the investment universe is large. However, this is not to say that these types of strong returns are to be expected to continue indefinitely.