The potential of compound interest can achieve amazing things.
There’s not a lot you learn at school that has much relevance to investing. Mostly it’s about developing a base of knowledge in any particular industry and then using some good old common sense—and these are things you pick up via books, tv or chats at social gatherings and experience of the wide world rather than in any classroom. But there is one thing you should have learnt at school that’s vitally important to investing, and that’s compound interest.
Unfortunately, if your school was anything like mine, compound interest was dealt with towards the end of double maths on Friday afternoon on the last week of third term. All thoughts and attention were other wise directed.
If this sounds at least a little familiar, and you haven’t since filled the gap, then this article is for you. Let’s take a look at compound interest at work.
Here is a little story to illustrate: Back in 1970, two brothers, Geoff and Steve, each inherited $10,000 worth of shares in Acme Manufacturing Corporation (AMC). Over the years, AMC stock has risen at a average rate of 8% a year, but it has paid an average dividend of 7%.
Living The High Life
Now Geoff has always lived what he himself calls the ‘high life’, and he’s always needed his AMC dividends to help fund it. Still, his holding is now worth $149,740 and this year’s dividend of $11,980 will cover the lease payments on his series 3 BMW. Steve, on the other hand, has always been more restrained. That’s not to say he hasn’t had a good time, but his nights out have been less extravagant and they’ve always been paid for out of his income as a truck driver. So Steve’s AMC dividends have always been reinvested via the company’s dividend reinvestment. But with his desire to work long hours has declined and with wife Sally considering retirement, Steve is thinking he might just start paying the dividends into his bank account. This year he’ll get $214,290, from a shareholding worth $2,678,640. Oh compound interest you are awesome my friend!
But as we all know, there’s no such thing as magic. Just as a magician sticks untold number of sharpen swords into the box containing his attractive assistant who manages to survive with the clever use of smoke & mirrors, compound interest wields its incredible power through the simple multiplication. It’s just that when you keep multiplying year after year, without taking anything out, then you multiply the bits you’ve already multiplied and after a while it really starts to mount up.
In Steve’s first year, , his shareholding grew by 14.75% of the original $10,000 (including the reinvested dividend)—or $1,480, leaving him with $11,480. But in the second year, he made 15% on the original $10,000 again, that is $1,500, plus 15% on the $1,480. In the third year, he made 16% & etc.
The Amazing Rule of 72
The way it works out, Steve’s holding doubles about every 5 years, so by the time 40 years are up, it’s doubled about 8 times. Geoff’s holding, on the other hand, takes around 10 years to double, so he only manages to double 4 times in 40 years. A handy rule of thumb, called the ‘rule of 72’, is that you can get the number of years for a doubling by dividing 72 by your growth rate.
The Lesson Here
A very simple lesson can be gained here. Hold onto your capital and be patient to grow it and the sky is the limit!
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