Before I give you my answer I would like to establish in your mind that time is money. The secret to getting rich slowly is what I would call the ‘miracle of compound interest.’ The words ‘compound interest’ are two of the most powerful words in the investing world. Albert Einstein famously stated, “Compound interest is the eighth wonder of the world. He who understands it – earns it. He who doesn’t – pays it.” There are some people who dispute that Albert Einstein made this statement. Regardless of who said these words it should not take away from its true meaning – compound interest can be your best friend.
So, what was my answer to the above question? “The Rule of 72!” It appeared I had caught the interviewer off guard so I asked her, “Do you know the Rule of 72?” When she said it wasn’t the response she was expecting I explained to her that it is a rather simplified method to determine how long it will take for an investment to double. If you divide 72 by a rate of return, a person can get a rough estimate of how many years it will take for the initial investment to double. Since this was for a position that required detailed tasks, I thought this might demonstrate some financial acumen. Bottom line I did receive the job and have used the rule of 72 in various capacities.
Some people reading this blog are visual in nature. Here is an equation that will help you visualize this mystery of compounding. The equation is A x B = 72. The variable “A” is the number of years it will take you to double your money and the variable “B” is the percent rate you can earn on your money. This equals 72.
Let’s work on an example. For instance, let’s say you want to double your money in 9 years. What rate of return to you require?
9 x B = 72 so B = 8.0 percent
Another way to use the rule of 72 is to divide any percent return into 72 to see how long it will take you to double your money.
Here’s a second example. Let’s say you can get 6 percent on your money.
A x 6.0 = 72 so A = 12 years
Finally, let’s say someone (probably a financial manager who is trying to sell you an investment) tells you that an investment should double in four years. What rate of return should you expect from that investment?
72 divided by 4 = 18 percent – not impossible, but something that needs due diligence to check out the risk involved
Investor.gov put together a Compound Interest Calculator that will quickly determine how much your money will compound given certain items such as Initial investment, contribution amount, interest rate and how quickly you want to compound your investment. You can find the calculator here.
The reason why your parents or guardians encouraged you to save and invest early in life is all due to the power of compounding. If only we could have trained ourselves at a young age to do what we now know – we would all be millionaires or better.
Benjamin Franklin liked to describe the real benefits of compounding by stating, “Money makes money. And money that money makes, makes money.”
Don’t let this concept escape you. Compound interest wasn’t called the 8th wonder of the world by one of its most forethought thinkers – Albert Einstein and many others that have taken advantage of its power!
Quote of the Day: “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffet, considered the most successful investor in the world
