Understanding And Using The Magic Of Interest Compounding

Simple But Powerful Tool For Young People To Build Wealth

If I recommend the power of compoud interest to young people, don't get me wrong: even middle-aged and elderly people can still benefit from compounding. But, as you will soon discover, compounding has a strong ally in time. Together, they do great things. You can then see why younger people, with more time on their hands, can also do great things if they understand the magic compounding and the results it can deliver. A young person, who learns the powerful impact of compounding, can be profoundly influenced by this concept in making choices early in life and can indeed achieve phenomenal results in good time. A parent who, at the birth of a child or while he is still a toddler, engages the factor of compounding in setting up the child's financial future, may find that he only has a modest effort to make now, while compounding, with its friend, time, will do the rest.

What Is Compound Interest
Compound interest is interest that is added to the principal sum at the end of the investment period and both are reinvested as principal for another term. Interest in the second period is calculated on the initial principal plus the first period's interest. More properly put, the interest in the first period is capitalised, making it effectively part of the principal in the second period. This is called compounding of interest, different from simple interest which does not capitalise the periodic interest. Note too that this basic concept of interest compounding can be stretched beyond interest capitalisation. The idea can be applied to investment in stocks, for instance, if you hold a good stock and reinvest dividends and bonuses. The impact, over time, could be dramatic.

The Harvard University Study
A major study was undertaken by one sociologist at Harvard, Dr Edward Banfield, aimed at identifying how and why some people became financially independent during their working life. His findings, published in 1970 in a book entitled The Unheavenly City, showed that the major factor for success in those who attained financial security was what he termed "long time perspective". He discovered that those who took a longer time perspective in planning and working on their financial goals were more likely to achieve greater success. This is also the turf on which compounding plays.

Dramatising The Impact
One way of explaining the impact of compounding is by illustrating the results with hypothetical cases. One interesting illustration is in the story that a native American tribe sold Manhattan in 1626 for goods worth 60 Guilders. Calculation shows that if that sum of 60 Guilders was invested then at 6.5% compounded annually, it would have been worth €700billion by 2005. Now, nobody can wait that long for the benefit of an investment, but it makes the point! Lets, however, look at another shorter-span illustration:

A single investment of N100,000 at 10%, compounded annually, will produce the following results, over 50 years:

Number of Years	Value of N100,000 compounded at 10%
1	N 110,000
2	N 121,000
3	N 133,000
4	N 146,000
5	N 161,000
10	N 259,000
20	N 673,000
30	N 1,475,000
40	N 4,526,000
50	N 11,739,000

If this compounding is done more frequently, say monthly, the result dramatically increases. For this example, the 50th year value will be N14,537,000 if compounding is done monthly.

What comes across, clearly, is that if compounding is given sufficient time to work on an investment, it generates value growth that could seem disproportionately high.

The Impact of Timing
Timing has critical areas of impact on compounding. The first is that the frequency of compounding can leave a major impact on the result. If compounding is done half-yearly instead of annually, the yield is higher. If done monthly, the impact becomes even more significant. Again, it's important to note that accelerated savings will produce better results than when delayed. You are better off plugging in your saving early, than waiting to do so years down the road. Higher volumes of investment at that later stage will not enjoy the benefit of the long time span which provides the fertile ground for compounding to work. So, you get less for more!

How To Profit From This
Building a strong investment portfolio goes beyond putting some money in a savings or other deposit account for compound interest. But it is an important part. Besides, you need to accumulate funds for other investments. Bits of savings, over time, can build your seed capital. Understand, too, that the idea of compounding can be applied to various investments. Compounding does one good thing: it helps you to see, in bold relief, the impact a long term perspective can have on your financial capacity. If we see this properly, we may never really be poor in the long term. How? By taking the modest actions today, which, over one's lifetime, are capable of transforming him without extraordinary effort. All you need are consistent, modest and timely investment actions and some patience and the rest will literally happen on its own. The problem is that many live from day to day and do nothing to change the course of tomorrow.

If you think and act differently, you will escape this trap and your future will come out looking good. If you don't have the patience for skimping and waiting for years to grow your investments, I suggest you read Seven Years To Seven Figures by Michael Masterson for a fast track formula. Who knows, it may work for you.

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