“The most powerful force in the universe is compound interest”. – Albert Einstein
One of the most important things you need to know about investing and becoming rich is “Compound Interest”. It’s a concept that everyone thinks they understand but in reality do not.
Compound Interest is actually a very difficult concept to grasp because our brains are wired to think linearly not exponentially. For example, if I came to your house and gave you a magical rabbit that grows in size by a pound a day, how many days would it be until the rabbit becomes big enough to start creeping you out? You can quickly do the math in your head; say a rabbit weighs 5 pounds, so after 60 days the rabbit would be 65 pounds, so a rabbit no matter how cute being the size of a beer cooler starts to become creepy. The math and visualization for that problem is very easy for us to grasp since the growth is linear.
Now let’s try an exponential problem. Let’s say we take a football stadium and make it water tight and I kneel on the 50 yard line with an eye dropper and each minute double the amount of drops I put on the field, how long would it take me to fill up the whole stadium?
Minute 1 = 1 drop from the eye dropper
Minute 2 = 2 drops from the eye dropper
Minute 3 = 4 drops from the eye dropper
Minute 4 = 8 drops from an eye dropper
….and so on.
(Photo: Rogue Soul)
At this rate how long would it take me to fill the whole stadium? Take a guess? A day, a month, a week? The answer is under 50 minutes. That’s right, starting with 1 drop from an eye dropped and doubling every minute you can fill up the whole football stadium with water in less than 50 minutes.
Now how long would it take to fill up all the world’s oceans? Take a guess. The answer is under 90 minutes. And a little over 90 minutes to fill up all the volume of the earth.
(Geek Alert: I show all the math here)
So if we start with one drop from an eye dropped and double the number of drops we would be able to fill up all the world’s oceans in less than 90 minutes. That is the power of compound interest, and as you can see it is very difficult for us to calculate and visualize it. But this is the most powerful tool in growing your wealth and becoming rich.
The secret to growing your wealth is putting as much money away as you can and not touching it and allowing it to grow with compound interest. The most amazing thing is that the longer you do nothing the more you are rewarded.
Let’s say we put away $10,000 and can grow it at 10% a year.
For doing absolutely nothing and leaving your money to grow you have more than doubled it. The beauty of it is that each year you get rewarded more and more for doing absolutely nothing. The first year you do nothing, you are rewarded $1000 but by year 10 you get paid $2144 for doing absolutely nothing. There are not very many things in life that allow you that luxury.
When I still had my day job, I was making average salary, living in a tiny 1 bedroom house where I was paying $640 a month rent, and driving a Hyundai Excel. Every 2 weeks when I got my paycheck my order of business was to write a check for half my salary to invest in an index fund and the other half I would deposit in my bank for expenses. I forced myself to live on 50% of my salary. Even if everything stayed the same in my life and I continued to make an average salary, I would still be rich today due to saving and compound interest. You do not need to be rich to become rich.
I am certainly not saying you need to deprive yourself of everything, but what I am saying is that everything you buy which depreciates in values is contrary to you becoming wealthy and you are either making your money grow or making it shrink.
Many people think that they will one day wake up and be rich and they keep waiting for that day which will turn it all around for them. In reality, most wealth is created by simply putting money away and allowing it to grow slowly, systematically and methodically. Overnight riches are extremely rare.
The longer you can put off instant gratification of being a consumer the easier it will be for you to become wealthy.
Even the big creepy rabbit, although probably lacking magical powers, agrees with me.