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Einstein And The Theory Of Compound Interest

The Time Value Of Money

Albert Einstein believed that the most powerful force in the universe was compound interest, the process of putting a little money away now to become a little more tomorrow, a little more the day after that and, in time, growing to a very substantial sum. Many argue that the man himself didn’t actually use these words but, unlike the mathematical concepts of calculus and vectors, compounding can be applied to everyday life so we tend to believe there is a little bit of “genius” attached to it.

What Is Compound Interest?

Compounding interest or compound growth is defined as the process of generating earnings/income on an asset by reinvesting the generated earnings/income again and again. To work, it requires two things; the re-investment of earnings/income and time. The more time you give your investments, the more you are able to increase the income potential of your original investment.

Compound Interest – A True Story

In 2011, a wonderful story that epitomises this concept was reported in the Huffington Post, Ohio, USA, about a 100 year old lady, June Gregg, who held the same bank account with the same local bank for over 98 years. Her father had opened the account in January 1913 when she was only 2 years, old depositing $6.11. The account number changed only once when the Columbus-based Huntington National Bank acquired the plainly named “Savings Bank” in the early 1980’s. The bank toasted this amazing lady’s loyalty by throwing her a 100th birthday party, where she was happily interviewed about being the longest standing customer.

Ms. Gregg stated that her father, Gilbert, a farmer who grew corn, wheat and hay, was a Savings Bank customer and wanted his only daughter to learn thrift. He taught her to “stay out of debt”, “save her money” and “not buy anything until she could afford to pay for it”.

With the help of the account, Ms. Gregg is comfortable in retirement even after so many years and, although she has a current/checking account to pay bills, Ms. Gregg said she uses the savings account for "personal dealings"(2011).

For obvious reasons, the story does not report what her account is worth today but if we base our calculations on the historic averages of US interest rates, we can hazard a guess as to what Ms. Gregg would have earned over a 100 year period (1913 to 2013).

The annual US Interest rate in 1913 was circa 3.5%, this reached an all-time high in 1981 at 17% and an all -time low in 2008 at 0.25%*. Using compound interest, if the interest rates had remained static at ~3.5% p.a. her initiall $6.11 would have increased to $187.15, at 17% p.a. it would have been worth a staggering $39,512,765.32 today and at just 0.25%* p.a. a meagre $7.70.

This beautifully highlights the correlation between original investment, interest rate and time.

Of course, if Ms. Gregg had taken a leap of faith and decided to invest her money in the stock market, she may have actually done better…Warren Buffet style……he managed to produce an annual average return of 21.5% from 1965 to 2005, doubling the return of the S&P 500!**

When It Comes To Compound Interest, What Can We Learn From Einstein, Gregg And Buffet?

Over the last 100 years, consumer behaviour towards saving has varied. Goals were different back then, mainly because incomes were low and spending habits were more to do with being able to afford the basics in life and putting money away for a “rainy day” was an ideal rather than a reality. In 1901 for example, food and housing took up about 60% of people’s incomes and virtually nothing was spent on transport. Fast forward to the noughties, food and housing expenditure reduces to 45% with 22% being spent on transport#. It was only when incomes began to increase that people saw an opportunity to start saving but as Ms. Gregg has taught us, it’s important to start as early as you can.

It doesn't take a huge amount to get the ball rolling and the sooner you do, the longer you have for compounding interest to supercharge your returns.

All It Takes Is A $1 A Day

This might seem silly, but it’s a good philosophy to have because it shows discipline, proving you can do it. It’s also a long-term goal – you have a financial objective to meet (saving for education, saving for a wedding, saving for a comfortable retirement, saving for a new car…the list is endless) and this helps you keep an eye on your prize. It also builds confidence – you may read this article and think that you can’t invest in the stock market - it’s too expensive, you can’t afford to start your retirement fund now, you have other money commitments … but think, even if you did nothing but put that $1 in a cookie jar for 365 days, you’d have $365 in 1 years’ time helping you make a start on your journey to financial freedom.


Sources:

* http://ncalculators.com/interest/compound-interest-calculator.htm;
  http://www.tradingeconomics.com/united-states/interest-rate and
  http://en.wikipedia.org/wiki/Economic_history_of_the_United_States and http://www.excel-easy.com/examples/compound-interest.html

** http://www.coattailinvestor.com/

Important Notes:

Please note that this article is not an offer for sale and Generali International Limited is in no way presenting a recommendation of funds/asset classes or suggesting that one fund/asset class is better than another fund/asset class. Generali International does not provide investment advice based on individual circumstances. Investment decisions are the responsibility of the financial adviser and/or investor(s) and any choice of investments is entirely at their own risk.

The article is for general information only and must not be regarded as an offer or invitation to acquire an interest in or participation in a Generali International product.

You should note that investment involves risks. Past performance is not indicative of future performance. Investors and/or their investment advisers are responsible for their investment decisions and any choice of funds is entirely at their own risk. Please note that investment performance (as well as the income accruing to an investment) may go down as well as up.
 


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