Compound interest | Looking for Alpha

Compound interest is the eighth wonder of the world. Whoever understands it, wins it. Whoever doesn’t, pays.

-Albert Einstein

There is no such thing as compound interest. This amounts to a financial sprinkler system that keeps your money growing. It’s funny, in a weird way, a lot of people work really hard and do what they can to make money, but when it comes to making the money they’ve hoarded grow, they are blocked.

Compound interest is proof of the existence of God.

-Jeff Rich

The formula for annual compound interest, including the principal sum, is:

A = P (1 + r/n) (nt)
A = the future value of the investment/loan, including interest
P = the amount of the main investment (the initial deposit)
r = the annual interest rate (decimal)
n = the number of times the interest is compounded per year
t = the number of years the money is invested

Note that this formula gives you the future value of an investment, i.e. compound interest “plus” principal.

Compound interest is the root, the very heart of my “Cash Flow Investing” strategy. It is “making money on money” and is either a substitute for investing for appreciation or an alternative strategy used alongside it. I prefer monthly cash flow, if I can find it, which can be found in some of the closed-end funds I like. Every month, “Here’s the money.”

My wealth came from a combination of living in America, some lucky genes, and compound interest.

-Warren Buffett

There is also another important factor of monthly cash flow, namely compound interest, which is often overlooked. It’s the opportunities it gives you and the protection it gives you. One is the reverse of the other.

Markets have done, can and will do strange things. Political events happen and economic events happen and surprises always lurk in the shadows. Since you receive money every month, if you receive monthly payments, you are able to react to what might happen and that’s a “huge plus”, in my opinion.

If, for example, you owned ten closed-end bond/stock funds or MLP funds, paying monthly, then each month you can review your portfolio and decide which opportunity shines the brightest or you can add a new name, after you have done your homework. Here are twelve opportunities per year against a standard bond that only offers two. On the flip side, monthly payments also provide twelve opportunities a year to protect your wallet, should things go wrong, or worse, something you can rely on over time.

I think people don’t understand compound interest because usually no one explains it to them and the level of financial literacy in the United States is very low.

-James Surowiecki

The recent hype in the press is about Bitcoin. You might as well play craps, in my opinion. A few will win, many will lose, but of course the same can be said of a casino. Obviously that’s not what I consider an investment, that’s all I have any interest in doing. The game is just not my game!

Markets are a combination of gambling, speculation and investment. I have interest in the last two categories and none in the first. I’m not saying gambling is bad, but what I’m saying is you need to understand exactly what you’re doing when you put your money on the table.

Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t get carried away by the siren song of the market.

-Warren Buffett

Compound interest is a historically interesting concept. Compound interest was once considered the worst form of usury and was severely condemned by Roman law and the common laws of many other countries. The Florentine merchant Francesco Balducci Pegolotti provided a chart of compound interest in his book Pratica della mercatura published around 1340. Richard Witt’s book Arithmetical Questions, published in 1613, marked a turning point in the history of compound interest. He was all about the concept. Witt was a London mathematician and his book is worth noting.

The more we progress, the more we tend to progress. We are not advancing in arithmetic progression but in geometric progression. We draw compound interest on all the capital of knowledge and virtue that has accumulated since the dawn of time.

-Sir Arthur Conan Doyle

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