Why most people don’t get rich
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
– Albert Einstein
If you want to get rich, compound interest is probably the most important concept you need to get your head round. I’d say that most of my friends are in the latter camp – i.e. they are net payers of compound interest – i.e. they are helping someone else get rich. That’s through no fault of their own; they just don’t have the benefit of a financial education. But that’s a situation that websites like The Millionaire Marathon are looking to remedy…
According to Wikipedia, compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
In layman’s terms, it’s the snowball effect from reinvesting interest – the long-term effects of which can be very powerful. In fact, Einstein also called compound interest “the most powerful force in the universe”.
The most powerful force in the universe
To illustrate just how powerful the long-term effects of compound interest can be, here’s a simple example. Joe has just inherited £20,000 from his auntie. Being a cautious soul, his instinct is to keep the money in a savings deposit account, where rates are currently 1%. However, his financial adviser suggests Joe should put the money to work in the stock market, where long-term returns average around 7%. His financial adviser recommends a relatively conservative fund that invests in large blue-chip companies.
Finally, Joe’s uncle, a long-time investor, suggests that Joe should take a more adventurous approach and invest in a riskier smaller companies fund, where market volatility is higher but where long-term returns can be as high as 15% per annum.
The table below demonstrates the cumulative effect of the different rates of return over 20 years:
As you can see, the blue-chip stock market investment has outperformed cash by a considerable margin after 10 years. But after 20 years the gulf has opened up into a chasm – the blue-chip fund has left Joe with three times what he would have had if he had chosen cash instead.
But look at the performance of the small-cap fund! After 10 years the fund is worth almost double the value of the blue-chip investment and more than three times the value of the cash deposit. But after 20 years the small cap fund is worth a massive £284,635 – almost four times the value of the blue-chip fund and almost 12 times the value of the cash deposit.
While this is a relatively crude illustration – in practice market volatility will ensure a much bumpier ride for the stock market investments – it demonstrates the power of compound interest over long periods of time.
Inflation is a saver’s worst enemy!
As I mentioned earlier, most people are on the wrong side of compound interest because they have credit card debt or other forms of consumer loans that charge insane amounts of interest and charges. But even if Joe Public is lucky enough to have savings rather than debt, that money is often at the mercy of another great evil – inflation!
At time of writing you’d be lucky to get 2% interest in a savings account. But inflation is running at close to 3%. This means that anyone with cash savings is seeing the value of their money eroded by around 1% or more each year. (Inflation, if you don’t already know, is a general rise in prices of goods and services.)
Now, that certainly doesn’t mean you shouldn’t hold cash at all – in fact, I think now is a good time to hold quite a lot of cash as a proportion of your total assets, but that’s a story for another day.
What it does mean, however, is that cash is a very poor vehicle for building wealth over the long term. But unfortunately, it’s most people’s asset class of choice.