Compound interest is the answer, said personal finance enthusiasts.
Compound interest is the eighth wonder of the world, said Albert Einstein.
I’m not convinced, and on that one, I’m going to lock the horns with personal finance wisdom and a genius.
Call me contrary, but the glitz and glorification of compound interest leaves me called. Not because compound interest isn’t meaningful, but because it’s overstated.
Here’s the thing – your money can make money from compound interest, but for it to make a real difference, you need large sums of money or a surprisingly long time frame. And I mean multiple lifespans, which is why Twilight’s vampires are so incredibly rich.
You and I are human and have limited time and resources. You better believe me that compound interest is overrated and adjust your investment strategy accordingly.
(Oh, and before I go any further, I’m sure Einstein’s quote is misunderstood. In the eyes of a physicist, compound interest is a wonder because the money just seems to appear; it doesn’t happen. not produced in a universe where nothing is lost and gained.)
Simply put, compound interest is interest on interest and makes money grow faster.
It can work in your favor or against you. Compound interest accelerates the growth of your investments (depending on the frequency of compounding). It also causes your debt to grow rapidly.
We experienced capitalization when we were in debt and when we built up investments. It had a much bigger effect on us when we were in debt.
Have you heard of Ben Franklin’s experiment?
Alright, here it is.
In his will, Benjamin Franklin, who died in 1790, left $4,400 each to Boston and Philadelphia. His will stipulated that the cities would have access to certain funds after 100 years and would receive the rest after 200 years.
Now, the part that compound interest geeks are excited about: when the cities received their balances after 200 years, the combined bequest had grown to $6.5 million!
Can you see anything wrong with that?
Let me help you. Silver took 200 years to reach this staggering amount. You and I are not 200 years old.
One way to accelerate capitalization is to invest at a (higher) interest rate.
For example, assuming your investments are compounded at an annual rate of 10%, your money will double in 7 years.
It has been some time since investors have seen such annual rates of return. Most of us shed tears of joy and gratitude if we reach 5-6% per year. Often, the mass investor would settle for an annual return of 2%.
At a 2% annual return, your money will double in 35 years.
Another way to optimize capitalization is to start with a lot of money.
For example, if you have £20,000 compounded at an annual interest rate of 2%, in 10 years you will have the princely sum of £24,424. In other words, you’ve made £4,424 in ten years, which is probably less than the amount inflated by your money.
On the other hand, if you start with 2 million pounds at the same annual interest rate, in ten years you will have 2,441,588 pounds. That’s a compound interest of £441,558, which is more respectable.
Do you have £2 million to invest?
Expecting your investments to accumulate at 10% per year and to double every seven years sounds dreamy, doesn’t it?
When you check your account seven years from now, you might find that was what it was – a pipe dream.
Because you forgot to factor in inflation and taxes.
Capitalization takes a long time, and life, and black swans, can get in the way.
Banks can fail, the economy can collapse, there are pandemics, wars and other cataclysmic events.
What would have happened to Ben Franklin’s endowment if it had been made in Russia in 1790. Do you remember the Bolshevik Revolution of 1917?
Yeah. It would have seriously ruined the composition.
And the fact is that cataclysmic events are probable, possible and unpredictable.
Compound interest is speculative and derives from “interest on interest”, adding no value to the economy and to people’s lives.
Call me old fashioned, but “money for nothing” is a red flag for me. There may be problems down the line.
Have you wondered why banks offer you interest on your savings and investments?
Because banks de facto borrow money from you to lend to others and speculate. Yes, your money makes the banks a lot of money; they offer you a tiny part of it as interest.
I hope you now believe that compound interest, while important, is overstated. Ask people who tell you to start investing early because you lose compound interest. Challenge people who tell you not to spend on the daily indulgences that define your humanity (to me, that’s good coffee) because the money you spend today will be [insert some eye-watering amount here] in a hundred years.
More importantly, remember that investing in yourself is likely to accumulate better than investing in something else.
Building wealth takes imagination and brilliance, not dogma. And as beneficial as compound interest can be, it’s overrated.
Maria Nedeva, PhD, is a business school professor and creator of The Money Principle: a personal finance website where she teaches people in financial difficulty how to build lasting wealth. Maria Nedeva is the author of “Never Bet on Red: How to Pay Off Debt Fast and Live Debt Free Forever”