When I was a young boy, my granddad used to say to me “look after the pennies and the pounds will take care of themselves”. It was a phrase that stayed with me ever since and is a simple reminder that great results can be achieved through incremental improvements and there is probably no better example of this than compound interest.
Let’s start by defining the different two types of interest rates: ‘Simple Interest’ and ‘Compound Interest’. In the case of simple interest, a fixed percentage is added to the original (principal) amount each year. So, if I invested $5000 invested for 1 year at 10 per cent simple interest, then at the end of the first year I would end up with:
$5000 + $5000 x 10 per cent = $5,500
If I invested $5000 invested for 10 years at 10 percent simple interest, then after 2 years I would have:
$5000 + 2 x $5000 x 10 per cent = $6,000
And at the end of 10 years, I would end up with:
$5000 + 10 x $5000 x 10 per cent = $10,000
The beauty of compound interest is that the interest rate applies to the principal as well as the accumulated interest. So, if I invested $5000 invested for 1 year at 10 percent compound interest, assuming that the interest is only applied at the end of the term, the amount at the end of the first year would still be $5,500, but the second year’s interest would include the first year’s interest as well. Hence at the end of the second year I would end up with:
$5,500 + $5,500 x 10 per cent = $6,050
This doesn’t look like much of a difference but over a period of 10 years I would end up with $12,969, almost $3,000 more than the simple interest example.
The actual formula used to calculate the final amount achieved using compound interest is: P (1 + i)n
Where
P = the principal amount at the start
i = the annual interest rate
n = number of compounding periods
Of course compounding does not only apply to financials and its power has multiple applications as Albert Einstein understood when he said: “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
In his book ‘Atomic Habits’, James Clear also uses the power of compounding to illustrate how massive results can be achieved through small and regular incremental improvements. Specifically he cites the example that if you could make a 1 per cent improvement to something every day, then by the end of the year you would have made an overall improvement of 37 times the original performance. Conversely, if your performance decreased by 1 per cent every day, you would only be at just 0.03 times the original performance by the end of the year. Time to make those small incremental changes.
Ian Ash ACC, AInstIB
Managing director
OrgMent Business Solutions – www.ombs.com.au
