According to legend, Albert Einstein once said, “Compound interest is the eighth wonder of the world. Whoever understands it, earns it… whoever doesn’t understand it…pays it.
Although controversy swirls over whether Einstein actually said or wrote those words, there’s no doubt that compound interest is one of the most powerful – and least understood – concepts in the world of investing. . Why so powerful? Because understanding how compound interest works and using it to your advantage can save you money. Many over time. Credit union leaders understand the concept of compound interest, but many of your CU members may not. Why? I am confused. Maybe because it’s not usually taught in school. Perhaps because the topic of our own money seems to be a semi-taboo topic of discussion in our society. Maybe because it’s not sexy. Either way, it can’t be the result of complexity – understanding compound interest isn’t exactly the same as understanding the theory of relativity. But don’t be afraid. Here’s a plain English primer on compound interest and a way to explain to your members how they can leverage it over time to grow their investments, whether in a savings account, 401(k), SEP, IRA, college fund, or other investment.
Savings with reinvested interest do not grow in a straight line; it’s growing exponentially
Many non-financial people believe that savings with reinvested interest grow in a straight line – an arithmetic progression. As credit union leaders know, that is not the case; it develops in an increasingly upward sloping curve – a geometric progression. Compound interest, in the context of investing, is interest added to the principal, which then itself begins to earn its own interest from then on. Earn interest on interest. Very interesting. It is the interest payments generated by the principal of an investment account that are added back to the principal so that the previous interest also begins to generate interest itself. Like a snowball rolling down a hill. As the snowball (the main) rolls, it picks up more snow (the interest), which makes the snowball bigger, which makes the snowball pick up After snow every time. Before you know it, you have a big snowball. And you’re happy as a kid! This analogy is so apt that it was used in the name of a book about Warren Buffett, the greatest investor of our time – perhaps of all time. The book is called The Snowball: Warren Buffett and the Business of Life. Buffett is a buy-and-hold investor who generally prefers to buy stocks (often with “float” or premium payments from his insurance company holdings) and hold them for a long time while their price appreciates with the time and dividends (eg interest) generated by them are reinvested in the stock.
Fortunately, your members don’t have to be Warren Buffett to take advantage of the compound interest snowball effect. And they don’t need to study all the genius formulas on Wikipedia’s “Compound Interest” page to reap the rewards of this slow, quiet financial wonder. Just snowball into a 401(k), SEP, IRA, or kids’ college fund and keep adding to it automatically every two or four weeks with payroll or bank account deductions. Then go down a hill (on a slope they feel comfortable with and that works for them) by investing in reputable mutual funds, stocks and/or bonds that they understand. They shouldn’t expertly throw it down a steep, rocky, double black diamond track unless they know the risks and are prepared to live with the possibility of their snowball smashing into a tree or rock afterwards. growing fast and big. On the other hand, they should beware of being too conservative by choosing an extremely conservative bunny hill which can result in very slow rolling and a small snowball, which may not create as much aggravation over time. time. And no matter the inclination, they should resist the temptation to temporarily keep the snowball from rolling while they dig out a piece of it to buy a new luxury car or take a vacation in Europe. While expensive splurges are fun, their poor snowball’s growth will be stunted by such interference as its mass and momentum will be impaired. Instead, suggest that they consider creating a separate “fun” account at CU with the idea that they will invade it guilt-free when the urge to splurge (within reason) moves them to the future.
The key to investing and reaping the rewards of compound interest is to let it work for investors by giving them plenty of time and opportunity. And (this is the hardest part) to really to know itself; your true risk tolerance, your financial goals, your overall financial situation in life, and your time horizon so that when your investment snowball slowly stops, it will be big enough to achieve your goals. If members do this correctly, as the snowball grows, their major contributions will pale in comparison to the cumulative effect. Over time, snowball growth may be fueled more by capitalization than by their contributions. Then, at the bottom of the hill, they can dig in, have a big snowball fight, and still have some to leave a few snowballs to their kids and grandkids.
All because of the eighth wonder of the world.