5♣ – Use Compound Interest

Use Compound Interest - it's money for nothing and a free lunch.

compound interest

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

Use Compound Interest – it’s money for nothing and a free lunch.

Time is money. – Benjamin Franklin

Compound interest is the greatest mathematical discovery of all time. – Albert Einstein

The most powerful force in the universe is compound interest. – Albert Einstein

Compound interest is the eighth wonder of the world. He who understands it is destined to collect it. He who doesn’t is doomed to pay it. – Albert Einstein

Einstein seems to have had a lot to say about compound interest.

  • But whether he did in reality or didn’t, don’t worry – this stuff is not like relativity.

Compound interest is not complicated, nor is it difficult to take advantage of. ((Relativity isn’t that complicated either, though it is a little harder to take advantage of ))

It’s simpler with an example. Let’s say you put down a deposit of £1000 into an account that pays 5% pa (don’t we all wish there was such an account right now?).

  • So after year 1, you have £1050 – £50 in interest has been added.
  • But after year 2, instead of £1100, you have £1102.50. Because the second year of interest is based on £1050, not £1000.
  • So you’re £2.50 further on than you expected.
  • The next year, you would be £7.63 ahead.

Whoopie-doo, you’re thinking – £2.50. That’s just a cup of crappy coffee. Or after two years, three cups.

  • This is true, but it’s also the start of the snowball.
  • Stick with it and it will become very significant.

Here’s a way to think of the snowball effect. Imagine a pond with lilies growing on it.

  • On the first day, there is one lily.
  • On the second day there are two.

Each day the number of lilies doubles. After 30 days, they cover half the pond.

How long before the pond is full?

  • That’s right – just one more day.
  • Thirty days to cover the first half, one day for the second.

That’s the snowball effect.

When you are investing, it can seem for years that you are getting nowhere.

  • Then suddenly the snowball kicks in, and you’re there.

I speak from personal experience.

  • At age 42, I had to abandon work that I enjoyed to take something that paid better.
  • At age 45, I could see no way to retire.
  • Six years later I was retired at 51.

Let’s go through a few examples – some real and some imagined – to show you what can happen, and why getting started is so important.

The first example is a fable. A king (or an emperor, depending on the version) and a travelling sage (or the inventor of chess) are playing chess.

The king fancies himself as a chess player and offers the sage any reward he likes if he can win.

The sage asks for a single grain of rice on the first square of the chessboard, and double that on the second square. Then double what is on the second square on the third square.

  • And so on, for all 64 squares on the board.

The king lost the game, and ordered a bag of rice to be brought to count out the grains.

Except the bag wasn’t enough.

  • By the 20th square, 1M grains of rice were needed.
  • By the fortieth square, 1 bn grains of rice were needed.
  • And by the 64th square, 18,000,000,000 BILLION grains of rice were needed.

This is 210 bn tons of rice – more than all the rice in the world, and enough to cover India with a layer a metre thick.

So the sage can’t possibly get his rice.

  • In some versions of the story he becomes a high-ranking advisor to the king.
  • In others he is executed.

The “second half of the chessboard” has become a term in tech for the point at which an exponentially growing item becomes significant economic factor in a company or an industry.

See also:  5♥ - Pay yourself first

Now admittedly this story uses compounding at 100% pa (which we can’t achieve in investing) and for 64 years (which most of us don’t have left).

  • But you see the potential.

Here’s an example from the real world. You’ve heard of Warren Buffett, haven’t you?

  • Legendary investor, friends with Bill Gates, hosts the “Woodstock of Capitalism” each year at the annual meeting of his company Berkshire Hathaway.

Warren got rich by compounding up his wealth at around 20% a year. Sounds quite moderate, but that’s actually a terrific result.

  • I’ve managed 10.7% pa over the past nine years – when I’ve been counting carefully.

But Warren isn’t twice as good as me, he’s a thousand as times as good as me – and thousands of times richer. ((He’s also nearly thirty years older than me, so I have time to catch up a bit ))

Warren is in his eighties, and he’s worth more than $60bn.

  • But the interesting thing is that 99% of his money was made after he turned 50.
  • Indeed, 95% has been made since he turned 60.

When he turned 50, Warren was “only” worth $600M.

The third story is from the real world too, even though it will sound like I’m making it up.

There’s a 25-year-old guy called Max-Herve George, and because of compounding, he could end up owning Aviva PLC, an insurance company worth tens of billions.

  • And all from a dull life insurance policy based around unit trusts.

The policy was marketed by a local company in France in the 1980s and 1990s.

  • It had the unusual feature that you could switch funds using last week’s prices.

Prices came out every Friday evening, and until next week’s price, trades were carried out at the old price.

  • So on Friday morning you could see which prices had increased the most (or lost the least, if it was a bad week) and switch your money into those funds.

Each week, this is only a tiny advantage – maybe 1% – as fund prices don’t move around that much.

  • But compounded up week after week, year after year, it makes an enormous difference.

When the policy came out (1987), the internet didn’t exist. Tracking down prices was difficult, and deals were done by phone.

  • Taking advantage of the loophole was a lot of effort.

In 1997, Max’s Dad took out policies for the whole family, and started arbitraging.

  • At this point Max’s policy was worth €8,000.
  • He was seven years old.

This tipped off the insurance company (later taken over by Aviva) and they offered holders of the product £10 to switch to something else.

  • Like sheep, 90% of holders did.
  • Max’s policy was worth €13.5K at this point.

Aviva took the 200+ holdouts to court from 2005, but they have lost 64 cases so far.

  • The George family won their case in 2007, when Max’s policy had grown to €1.4M, and was increasing by 69% pa.

Aviva changed the rules so that fund switches had to be by hand-delivered letter, but Max’s Dad carried on.

Most of the holdouts have died or settled, but Max is one of around 30 left (the one who will talk to journalists).

  • By now, Max’s policy might be worth €150M.
  • More importantly, in around 10 to 15 years, it will be worth more than Aviva (who can’t compound the value of the company at 60% pa).

All from an €8,000 policy taken out 30 years previously.

  • And all because of compounding, with a little help from time-travel.

I hope these three examples have convinced you that compound interest is something you need to take advantage of.

The other thing to remember is that this all works in reverse with debt.

  • You take out a bit of debt on a credit card at 30% pa (or worse still, a pay-day loan at 1000% pa) and the debt spirals out of control.
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Avoid debt on anything that isn’t a house.

I won’t go into formulae in this article, but there’s a handy rule of thumb that will help you to calculate the effects of compounding.

It’s called the rule of 72.

  • If you divide 72 by your percentage growth rate (interest rate), that gives you the number of years it will take for your money to double in value.

So if you have an interest rate of 3.5%, it will take 20 years for your money to double.

  • At 7%, it will take you 10 years.
  • With my historic rate of 10.7%, it takes me 7 years to double my money.

And Warren only takes three and a half years to double his money.

The problem with compound interest is that the majority of its benefits lie far off in the future.

  • The benefits gradually snowball, until they are unmistakable, but not for quite a few years.

This means that there’s no immediate incentive to get started today.

  • Which in turn puts back the day of the snowballing benefits.

Let’s look at what you should do instead.

The first rule is to get started as soon as possible, ideally in your twenties.

  • To go back to the idea of your money as a snowball rolling down a hill, getting bigger as it goes, this is like starting at the top of the highest hill that you can find.

Investing careers these days can last fifty years (from 25 to 75, say).

Most of the examples you’ll see in articles about compounding use unrealistic rates of 10% pa to make the numbers look dramatic, but even at a more realistic 4% pa (after inflation), £1 becomes more than £7 over 50 years.

That means that those £100 trainers you bought aged 25 have cost you £700 of orthopaedic slippers when you are 75.

  • It also means that savings from your twenties are more than twice as effective as savings in your forties (4% pa over thirty years turns £1 into £3.24).

So save young.

And save aggressively. The compounding rate makes as much difference as the time you save for.

  • If you got 1% pa for 50 years, your £1 would only change into £1.64, not £7.

Conversely, the difference between 7% pa returns and 8% pa returns can be enormous over a long period.

  • When you are young, you can’t stick your money into cash, you have to take a risk on stocks.

Rule number three is look out for costs and taxes.

  • There’s no use getting an extra 1% pa return if you hand it to the tax man, or to some investment manager.

And the cumulative effects of these taxes and fees compound up like everything else.

  • A 1% charge over 50 years means an awful lot of money has been wasted.

Use your SIPPs and ISAs, and shop around for the cheapest deal.

The frequency of compounding also makes a difference.

  • With most risk assets, returns are continuous, but with cash and bonds, you are credited with interest at fixed intervals (yearly, quarterly, monthly etc).

The shorter you can make those intervals, the greater the compounding effect you will achieve.

The fifth and final rule of compounding is that you have to leave the money alone.

  • You can’t dip into the account and steal some of the interest.

In fact, the less you look at it, the better. If you’ve invested in risky assets as you should, the value will fluctuate.

  • That means down as well as up.
  • We don’t want you making any emotional decisions about what to do with your money.

Treat the money you put away as gone until you need it, decades into the future.

  • Good things come to those who wait.

So use compound interest – it’s money for nothing and a free lunch.

Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 39 years, with some success.

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5♣ – Use Compound Interest

by Mike Rawson time to read: 6 min