"Take a simple idea and take it seriously."
— Charlie Munger
In the world of investment, an idea of compound interest must be taken very, very seriously. Understanding the power of compound interest in getting the long-term value of what you pay today is the heart and soul of investment.
Compounding is the process of continuously reinvesting gains such that each subsequent gain begins earning a return itself. Einstein is said to have called compound interest the eighth wonder of the world and said that “those who understand it, earn it, and those who don’t, pay it.
Warren Buffet was convinced by his mid-twenties that the power of compound interest was going to make him rich. In his many annual letters of Berkshire's partners, he emphasized the importance of compound interest in long-term investment. In his letter in 1965, he gave an example of compound interest that a $100,000 invested for 20 years at the rate of 12% would turn into 1 million.
The chart below shows the worth of $10,000 at the end of 20 years at different interest rates.
"My wealth has come from a combination of living in America, some lucky genes,
and compound interest." – Warren Buffett
Calculating the Compound Interest
Let's assume you have $10,000 to invest today and you want to know the worth of your $10,000 at the end of 15 years if invested at 8% per year compound. The simplest way to calculate is to use this formula:
PV is present value (money you want to invest today)
R is the interest rate
N is the number of years
Type this formula into a cell on a worksheet to get the worth of your investment at the end of 15 years:
The Rule of 72
For many, the above calculation could be a little overwhelming. To further simplify it, you can apply the rule of 72. In this rule, you ask only one question, how long does it take for me to double my money?
Let's assume you have been offered a 10% interest rate by a bank and you want to know how long it will take to double your money. The answer is simple, divide 72 by the 'rate of interest' (72/10 is equal to 7.2). You will be able to double your money in 7.2 years. The video below is a great demonstration of The Rule of 72.