You should have no interest in interest, but plenty in the power of compound returns.

Einstein Quote- "Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it.

Albert Einstein is mainly known for his contributions to physics, but his wisdom didn’t stop there. In a lesser-known quote of Einstein’s, he called compound interest the ‘eighth wonder of the world’. However, the rates of interest that savers can get hold of now are gone and have been at record lows for many years.

So is Einstein’s quote still relevent today? In this article I will explain how what he was saying is still very important to understand. This is because it does not just apply to interest but to all forms of earning a regular return on your money. I will tell you precisely what Einstien was referring to as the eighth wonder of the world, and how you can harness this to help ensure your long term financial success.

The eighth wonder of the world

Einstein’s quote may seem like an exaggeration, but what he was saying should not be taken lightly. He is referring to money’s ability to grow by more and more each year due to interest. Have a look at the graph below to see what I mean

The growth of £1,000 earning different rates of interest over 40 years

A graph showing The growth of £1,000 earning different rates of interest over 40 years

As can be seen on the graph, the longer you hold money earning the same rate of interest, the bigger the gains you make every year. At lower rates of returns, this difference is pretty lacklustre. Earning 1% interest per year on £1,000 earns you £10 of interest in year 1 and £14.74 in year 40. However, as the interest rate gets larger, this effect multiplies. At 10% interest you would be earning over £4,000 every year by year 40, that’s 4 times the initial £1,000! 30 or 40 years may seem like an unrealistic amount of time, but when considering saving for retirement, this is a reasonable time horizon.

Those who understand it, earn it, those who don’t, pay

Definition of inflation- The decline of the ‘purchasing power’ of a currency over time. This is driven by prices of goods and services increasing, meaning the same amount of money can buy less. For example, inflation of 2% in a year means the same amount of money can, on average, buy 2% less goods and services at the end of the year than it could at the start.

While it was possible to get a good rate of interest on your money in Einstein’s day, the chances of earning over 1% per year on your money in a bank account or from bonds is currently slim to none. In fact, as interest rates are normally less than inflation, keeping your money in a bank account means you are effectively paying to save your money.

However, interest isn’t the only possible way to benefit from the effect that Einstein is referring to. Investing is another. While earning 5-10% in interest per year on your savings in the bank is essentially impossible, expecting this much from investing in shares is perfectly reasonable by historical standards. If you earn such returns for long enough, the full benefits of compounding returns, similar to those you saw on the graph above, can be felt.

It is important to understand that investing is riskier than earning interest. Market crashes can last a year, two or in rare cases even longer. However, as long as you are able to leave your money invested for long enough, the market should recover and surpass previous levels, if the entire history of the stock market is anything to go by, that is. It is sensible to plan ahead with investing, ensuring that you won’t need any money you put away for at least 5 years. Investing money which you might need may force you to sell investments when the market is down and crystallise your losses. If you are not risking money you may need to call upon what really matters is the long run rate of return, not their short-term volatility.

For instance, the global equity market has had two years in the past ten where it finished below where it started, 2011 and 2018. It also contained some of the most severe market swings since records began last year as the market reacted to the news of the pandemic. However, despite this volatility, the global equity market has posted an average return of 11.7% per year over the last 10 years (to November 2020)1. Money earning this rate of return will double in value around every 7 years.

Time is Money

One example that demonstrates the power of compounding returns is the story of Warren Buffett. Buffett is a household name even for those who know little about investing. His current wealth is estimated at around $90 billion.

Picture of Warren Buffett sitting in his office
Buffett in his office, where he has worked for over 60 years

There is no disputing that Buffett is a great investor. There are literally hundreds of books that claim to teach you how to follow in his footsteps. However, almost none of them will tell you about Buffett’s secret to the staggering amount of wealth he holds today. But the real answer is incredibly simple: time.

Buffett made his first investment at just 11 years old, and he is still going strong at the age of 90. This means he has held investments for around 80 years, one of the longest periods of any single person on the planet! Although Buffett has been incredibly successful, his wealth did not reach the levels that would make him a household name until after around 50 years of investing.

Warren Buffet’s wealth at different ages

Warren Buffet’s wealth at different ages
Buffett has made over 90% of his fortune since turning 65

If Buffett started investing when he was 25 instead of 11 and earned exactly the same level of return until his retirement at 65, he would be worth $11.7 million. This is still very good going for someone who essentially started from scratch, but is a mere 0.013% of his current net worth.

This isn’t because Buffett suddenly became a better investor in his 50’s. In fact, his outperformance of the market has been declining for decades and he has even underperformed in recent years2. Buffett’s massive accumulation of wealth is simply down to the fact that he has consistently been earning a good return on his money for the best part of a century. He has benefited from the full power of compound returns.

What does this mean for you?

Buffett is perhaps the best example to demonstrate how great benefits of the compound returns from investing can be. While you may not make billions, getting a good return on your money rather than letting inflation eat it away is crucial. It means the money you have already have will work towards your goals for you, and the longer it is left to work, the more you will benefit.

It is particularly important to consider investing when it comes to retirement. It may seem distant, but it is the best opportunity you have to earn compound returns on your money precisely because it is such a long way away. Compound returns mean generally that, the earlier you invest, the less you have to invest in total to have the same amount by retirement. Be on the lookout for my follow up article, which will look at this topic in more detail by telling three different stories of people preparing for retirement.

Do you want to start investing but are not sure where to begin? I have a new series of articles which should cover everything you need to know. You can find my first post here.

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. The above contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, platform or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

This article was produced for educational purposes and aimed at UK residents.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

12020, Albion Strategic Consulting, [paper available on request]

22019, Forbes, After a decade of underperformance, Warren Buffett should retire on top [LINK]

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