Albert Einstein once called compound interest “the eighth wonder of the world. He who understands it, earns it, he who doesn’t pays it”. The ability to earn interest on your interest, and how that multiplies over time, can be hard for the human brain to grasp because our brains are conditioned by evolution to think in a linear manner. If I asked someone on the golf course to make a friendly wager on the winner of each hole, starting with 10 cents for the winner of the first hole, and doubling the bet each hole, most people would drastically underestimate the result. By the 18th hole, the wager would grow to $13,107. Most would find it even more difficult to understand how large the bet was on the 18th hole, if I told them that on hole 9, it would still only be $25.60. This example shows how powerful compound interest can be as it leads to exponential growth.
Hole 1 10 cents | Hole 10 $51.20 |
Hole 2 20 cents | Hole 11 $102.40 |
Hole 3 40 cents | Hole 12 $204.80 |
Hole 4 80 cents | Hole 13 $409.60 |
Hole 5 $1.60 | Hole 14 $819.20 |
Hole 6 $3.20 | Hole 15 $1,638 |
Hole 7 $6.40 | Hole 16 $3,276 |
Hole 8 $12.80 | Hole 17 $6,553 |
Hole 9 $25.60 | Hole 18 $13,107 |
In ancient India, Sissa, a Hindu Brahmin, invented the game of chess for an Indian king. The king was so pleased, he asked Sissa how he wanted to be rewarded. Sissa said he wanted only one grain of rice (or in some versions wheat) on the first square of a chess board, which was then doubled on every subsequent square.[1] By the 64th square the king owed Sissa 18,446,744,073,709,551,615 grains of rice, which was equal to about 210 billion tons.[2] Sissa, knowing it was impossible for the king to pay, agreed to allow him to pay over time, making him one of the richest men in the country. There are many different versions of this story, but the sticking point is that it’s extremely easy to underestimate the power of compound interest and exponential growth.
The same concept applies to investing. Warren Buffet, probably the greatest long-term investor of all time, has a net worth of $121 billion. However, at age 55 he wasn’t even worth $1 billion, he finally crossed that number a year later at age 56. At age 60 he was worth 3.8 billion, at age 72, $35.7 billion. He accumulated 99% of his wealth after age 50.[3]
Buffet compares compound interest to rolling a snowball down a big hill, the bigger the hill, (the longer the time horizon), the bigger the snowball will grow. "You'd better be picking up snow as you go along, because you're not going to be getting back up to the top of the hill again.” Buffet quipped.[4] The lesson here is that the earlier you start saving and investing, the more you’ll be able to benefit from compound interest. Bigger hill, bigger snowball.
Disclaimer: The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.