November 21, 2019

2 min read

The magic of compound interest
Compound interest – do you see the magic?
Nicholas Flaherty Image

Nicholas Flaherty - Investment Strategist - FWU Invest S.A.

Sometimes it’s hard to be passionate about finance; our subject area is pretty dry and of course is dominated by numbers. But there are a certain concepts and ideas that really do merit being passionate about. One of these is the idea of compound interest. Even the great Albert Einstein noted that it is the ‘eighth wonder of the world’!

What does it mean exactly? Let’s explain it using an analogy. Think of an avalanche and think how an avalanche becomes such a powerful force of nature. Before it turns into this vast deluge of snow, it must first begin as a snowflake, and once this snowflake comes into contact with others, it grows bigger and morphs into a larger layer of snow. Then as this snow shifts down the mountain, it collects other layers and keeps growing in mass and volume, ending in the deluge that we see in an avalanche.

Compound interest is the same: you can start small, but it keeps growing larger and larger as time goes on, ending in a large sum compared to the beginning. It is essentially interest on interest. Starting with 5000 EUR, for example, with a return of 7%, it would mean that the next period would start with 5350 EUR. Then the next time the 7% return is applied, it is no longer on the 5000 EUR, but rather on the 5350 EUR, meaning the amount the 7% is applied to keeps getting larger and larger, like the avalanche.
This means that even without contributing anything on top of the 5000 EUR, in 30 years’ time it will be worth just over 38,000, leaving a profit in that period of more than 33,000. By adding regular contributions, the avalanche simply keeps on getting larger and can easily reach hundreds of thousands. 

 

To bring it all together – there aren’t many exciting things about the world of finance, but the power of compound interest is definitely one of them. By continuously investing, you can turn small sums into very large ones, just through the process of time. It’s the ‘eighth wonder of the world’!

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