Compound interest: putting your money to work

You’ve probably heard of ‘compound interest’, but do you know what it is? Put simply: it’s about earning a return not just on your initial capital, but also by reinvesting your gains. It’s the closest many of us will ever get to a ‘money tree’, and yet, the majority of people underestimate its power. This can lead to poor financial decisions – such as the failure of saving early.
 

So how does compound interest work?

For example: Would you prefer to receive a million euros today, or a magical cent that doubles every day for a month? Most people would choose the million euros without thinking, but they could come to regret it over time. Why? Because according to our estimation, those who have chosen the magical cent, should be able to amass a fortune of €10.7 million euros by Day 31. 

This popular thought experiment demonstrates the concept of compound interest well. But the odds of finding magical coins (or investment opportunities) offering daily returns of 100% are extremely low, so let’s look at a more realistic calculation example below.

Let’s assume you’ve got €5,000 available and can invest this at a rate of 8% each year. You can choose to either withdraw your gains or reinvest them every year. The first option will allow your money to grow to €17,000 over 30 years. But if you choose to reinvest your gains, you’ll generate returns on both your initial capital and your accumulated earnings. The value of the investment should fluctuate at all time.

As Figure 2 of our thought experiment shows, the second option will see your investment grow to €5,400 over the first year. And the year after, you’ll earn interest not only on your initial capital of €5,000 but also on the €400 gain you’ve made in the first year. As you continue to leave your money during this example invested and earn returns on both your initial capital and accumulated gains, your investment will continue to grow at an accelerating rate. After 30 years, your investment will have increased tenfold to over €50,000.

Are you still unconvinced about what compound interest can do for your portfolio? Then read on to see how a one of the founding fathers of the US continued to help Americans hundreds of years after he passed away.

An unusual bequest: Benjamin Franklin’s compound interest experiment

Benjamin Franklin wore many hats during his lifetime: he was a publisher, a scientist, a diplomat, a founding father. He was also an inventor seeking solutions to common problems, creating things like the lightning rod and bifocal glasses. But the man whose portrait graces the front of the US$100 bill also had a lot of views about money that still ring true today.

When Franklin died in 1790, he passed most of his money and assets to family and friends. But as what can be considered a response to a joke, he also left instructions for two trusts to be set up with £1,000¹ in each for the benefit of the two cities he called home: Boston and Philadelphia. The hitch? Both cities had to follow a 200-year plan by Franklin that detailed how the money could be used.

The American polymath had calculated that even a low rate of return could transform a small amount of money into a jackpot, with time and compounding on its side. He stipulated that for the first 100 years, both cities were to invest the gifted money by providing craftsmen wishing to set up their own businesses with the 18^th century equivalent of today’s microloans. They would repay the loans within 10 years and be charged a below-market interest rate of 5%. The interest collected from those loans would be reinvested and compound over time.

Once those 100 years were up, the cities would be allowed to withdraw 75% of the funds for public works projects, but the remaining balance had to be locked away for another century – again being invested and loaned to tradesmen. This would allow the money to compound until the bicentennial of Franklin’s death, by which point he expected the money to have grown to approximately US$20 million for each city. Figure 3 shows the exponential rate of return that could be achieved through compounding.

Franklin is said to have been an irrepressible optimist. He expected borrowers to repay their loans in full, and he had also asked for the 200-year trusts to be managed by altruistic professionals willing to provide their services freely.

While his expectations didn’t quite match up with reality, over time, Franklin’s bequest provided personal loans to thousands of people over two centuries, built a science museum in Philadelphia, as well as a technical school in Boston. And when the trusts reached their 200-year anniversary in 1990, Boston’s trust fund had grown to US$4.5 million, while Philadelphia’s was worth US$2 million.

All of this was only possible due to the power of compound interest.

What a savings plan can do for you?

While we can’t all be Benjamin Franklin, most of us can still benefit from compound interest. A 30-year-old teacher from Hamburg – let’s call him Michael Schmidt – has recently inherited a sum of €25,000 from his grandmother. He decides to invest this in an ETF mimicking the growth of the MSCI World index. For the past 10 years (1 January 2012 to 31 December 2022), the index provided an annualized return of 8.11%.

Each month, he allocates €150 from his salary to his investment account, and he doesn’t withdraw a cent until he reaches the age of 65. Can you guess how much his portfolio would have grown by then?

In the 35 years between his initial investment and the day he turns 65, Michael’s portfolio could grow to €779,094. He would have made a €25,000 investment and monthly payments amounting to €63,000. But the growth of the investment alone could amount to €691,094.

The above calculation was done through our savings plan calculator. Why not try it out to see how saving regularly can help you meet your long-term financial goals.