Compound Interest, the eighth wonder of the world

On this episode of the podcast, we talked about all things compounding. Albert Einstein once famously said "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it."

The magic of compounding is that it starts off very slowly, but we liken it to a snowball rolling down a hill, it starts to gather speed and becomes bigger and bigger. Tim gave a great example of the power of compounding by sharing the centuries-old story about the con artist who scammed the king.

Naturally, there are plenty of different versions of the story, but the gist of it is that the King and a chess player had a game, and if the chess player won, he would get any reward he asked for. After the chess player won the match, the reward he asked for was simple - one grain of rice on the first square of the chessboard, two on the second, four on the third, and so on, doubling the amount of the previous square for the entire board.

The King, thinking he's got a great deal, agreed immediately and instructed his treasurer to pay out the winner with his prize. You can probably see where this is going. The rice was put on the squares, doubling every time, 8, 16, 32, 64, and so it went. By the end of the fourth row, the King needed 2.1 billion grains of rice and it was probably at this point that the King realised he'd been conned and wouldn't be able to uphold his side of the bargain. What was the total amount at the end of the board? 18,446,744,073,709,600,000. Try saying that number out loud, good luck!

The same principles work in your favour with investments. Now obviously you can't expect your investments to double every year, but the snowball effect really does play a part in the process. Arguably the greatest investor of all time, Warren Buffet, when asked about his success, said “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”

Compounding works best when you give it lots of time, which is why the earlier you start the better.