“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
People usually ask me whether or not I go for major profits in the trades I take and they usually seem surprised when I tell them that I don’t. When I first began trading, I was one of the many who desired big trades that would amount in triple digit returns. Those trades are possible and will happen for a trader every now then, but you can easily blow out your account chasing them. But…this article isn’t about trading in its entirety. I’m addressing this topic mainly for your average person who desires to retire a millionaire but have no clue as to how they can do it. For that crowd, I present to you — compounding interest.
Compound interest can be defined as: Interest calculated on both the principal and the accrued interest.
In simple terms — your investment gains interest on not only the principal (original amount invested), but on interest that has already been earned. Gaining interest on interest is key here because your average interest-bearing investment pays out interest only on the principal.
Here’s a hypothetical situation of how one would utilize compound interest to retire a millionaire. A person starting with $10,000 who also saves $1,000 monthly parks their money in an investment vehicle that yields 5% annually. After 40 years, their investment will have grown to 1,592,477.04. But, in order to achieve, this that person will have to continue to add on to their investment. The $1,000 that they save monthly which amounts to $12,000 annually will also have to be invested. Granted that you continue to invest (add on) that $12,000 every year, your original $10,000 will be $1.5MM in 40 years. Using these same numbers, except changing the interest rate to 10%, you’d get a return of over $6MM in the same 40-year period.
Finding an investment vehicle that yields 5% annually on a consistent basis, especially for 40 years, is going to be a challenge but of course you wouldn’t seek out only ONE investment. Since the point of this article is to make one aware of the effect of compound interest, I will recommend no investments. You’re going to have to do your own homework.
I can already hear a few of the critics saying that no one can realistically save $1,000 a month. Wanna bet? All it takes is living not within your means, but below your means. If you were to analyze your day to day life and watch where your money goes, you’d find out really quickly that you engage in a lot of wasteful spending without even knowing it. However, everybody’s situation is different. But if you’re single with no children, there’s no excuse for you to not begin now to look for ways to save money in every way possible.
The possibilities of growing money over an extended period of time as a result of compounding interest is endless. If you’d like to try it out for yourself, just simply go online and find a free online compound interest calculator and have fun. Key in some numbers and see for yourself the possibilities. By doing this exercise, it should help you to begin planning for your financial future. Just remember to use numbers in your calculations that realistically depict your situation.
Now….how does this pertain to trading? I’m not gonna get into too much detail because this concept is key to my money management system. But I will say this — instead of going for the home run trades, I instead go for base hits. Meaning that my goal is to make small but consistent profits and reinvest those profits. By doing this, I am compounding interest. Those small profits will amount to a staggering figure in a short time frame if the system is obeyed. Personally, I’ve gotten myself into trouble on a few occasions by trying to hit a home run on every trade. After learning about the effects of compounding interest, it didn’t take me long to realize that modest, consistent profits continually reinvested will get me to where I want to be faster. Besides, the risk/reward ratio is much greater.
To follow a concept like compounding interest takes a lot of discipline because your average person is going to be tempted to dip in their investment and take the first bit of profits they see. But for this to work, reinvesting is a must! By not reinvesting, interest would be gained only on the principal. Therefore, the key is to think long-term.
Conclusion: Compound interest is one of the most interesting concepts in the world. Supposedly, Albert Einstein stated that “compound interest is the greatest mathematical discovery of all-time.” Some have denied that Einstein ever made that statement but whether or not he did is irrelevant because there’s truth in those words. It is now clear how someone can live a pretty conservative life and retire rich, or if you’re looking to grow your money now, you could become wealthy a lot sooner than retirement age.