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Should the 7 Wonders of the World Welcome an 8th Member? Einstein Says Yes!

I’m sure that most of you have heard of (and perhaps some of you have even witnessed), the 7 Wonders of the World. Personally, I’ve just visited the Colosseum, so I have some serious work to do to check off the rest. I can say with certainty; however, that I’ve seen what Albert Einstein dubbed the “eighth wonder of the world”, Compound Interest, in all its glory.

Some of you reading this may have questions such as, “what is compound interest, anyway?”, or “how do I get it?”. Well, the actual definition of compound interest is the interest on a loan or deposit calculated based on both the principal AND the accumulated interest from prior periods. Simply put, compound interest can be described as earning interest on interest (allowing your wealth to snowball into a much larger fortune), distinguishing it from simple interest, where previously accumulated interest is NOT added to the principal amount of the current period—therefore there is no compounding. Simple interest is calculated by multiplying the daily interest rate by the principal by the number of days per period (typically used for automobile/short-term loans). The interest on interest is the key to growing your wealth exponentially, and why you sometimes hear people talking about making your money work for you.

Say, if someone was to offer you a choice between $1 million on the spot, or a special penny that doubled every day for 30 days, which option would you choose? It seems like a pretty stupid question, right? You’re probably taking the million and running! However, if you actually crunch the numbers your magic penny would’ve netted you about $5.4 million at the end of the month. You’re probably thinking “how is that even possible”, or maybe even something slightly more aggressive like, “this fool must have messed up these numbers!” If you fall into the latter group, I urge you to pull out a calculator and double-check! This example is illustrative of the power of compounding. Let’s just say the penny was to only give you 20 days of doubling—in such a case you’d only have a little more than $5,000, showing that compounding is all about time. You really start to see its impact on the growth of money as time goes on, which makes sense when you think about it, as increasingly large numbers are being compounded. While 100% returns are simply an unrealistic target (whether it’s over a month, year, etc.), the point of this example is just to show the importance of when you start investing.

Now let’s look at a more relatable, real-life example highlighting the beauty of compound interest. Say we have two gentlemen, Bert and Ernie, who are good friends and do everything together—everything except for investing, that is. Bert began his investing journey at the age of 19, investing $1,000/year until he turned 26 (total of $8,000 invested), at which point he decided to never invest another dollar. Ernie on the other hand wanted to live it up a little bit during his early-mid twenties (those are supposed to be the best years of our lives…can we really blame him??) and spent any extra money he had rather than investing it. However, when he turned 27 he smartened up and decided that it was time to start thinking about his financial future, so he also invests $1,000/year until age 65 (total of $39,000 invested—$31,000 more than his buddy Bert). Assuming that the two friends invested in the exact same equities and each earned an average annual return of 10%, which pal do you think ended up with more money when they turned 65? If you said Bert, you’d be correct - at age 65 Bert had approximately $76,000 more than Ernie, despite only investing about 1/5 of Ernie’s total contribution (See Exhibit A).

Exhibit A

I’m hoping you’re starting to see the trend here…WHEN you start investing heavily outweighs HOW MUCH you invest. Ernie invested nearly 5 times as much as Bert; the former invested $1,000 each year for 39 years compared to Bert’s eight, and yet Bert still had more wealth when it was all said and done. And why is that? Compound interest, of course! The investment return that Bert obtained in his eight early years of investing simply had more time to roll down the mountain and snowball into a much larger amount of money. The effect of those years on Bert’s wealth were so valuable that Ernie was unable to catch up to his friend’s savings, even with an additional 31 years.

So what should the takeaway be? Well, the secret to a comfortable retirement, like that which Bert was able to enjoy (in a stellar pad on Sesame Street I might add), is simply making consistent annual investments from an early age! The expression “if it sounds too good to be true, it probably is” applies to most scenarios, but not investing because it really is that easy! The real challenge is being disciplined enough to regularly set aside funds earmarked for investing when you have an already-tight budget. If you need some extra motivation to save, just think about Ernie, who enjoyed his younger years a bit too much and ultimately paid the piper as his financial choices prevented him from enjoying a luxurious retirement like that of his buddy Bert - surely you don’t want to be like Ernie, right?

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