The most powerful investment principle for expats in Europe
This article is about one of the most central investment principles, compound interest. Many have heard of compound interest, but its familiarity can mask the power of its application when it comes to building your wealth.
There is a famous saying that is often (mis) attributed to Albert Einstein – he probably never actually said it- but the quote is powerful.
“Compound interest is the eighth wonder of the world. They who understand it, earn it. They who don’t, pay it.”
Of course, we want our clients to harness the power of compound interest to achieve their goals.
In its simplest form, compound interest is earning interest on your interest. We can explain with examples and by first explaining the alternative, which is simple interest, and some key terms.
Key terms:
Principal (P)- this is the amount you invest
Interest- sometimes call interest, sometimes also called a dividend, or a coupon. It all means a return on your principal.
Interest rate (r)- this is an annual growth rate expressed as a percentage, eg 5% per annum.
Time (t)- this is how long you are investing.
Compounding frequency (n)- this is how frequently interest is compounded or added. It could be yearly, done once a year at the end of the year, it could be monthly, or it could be daily.
Simple interest is when you get an amount of interest on your invested principal. If you had €100,000 invested or saved at 5% per annum, accruing yearly, each year you would have another €5,000, but the interest would only be based on the principal amount each year.
If you held this investment structure for ten years, you would have €150,000, that is, the original €100,000 plus €5,000 each year for ten years.
For consideration of how this applies to your investments, this is how bonds work, if you ignore the potential returns (or losses) obtained by selling the bonds at a premium or discount on the secondary market. If you hold a 10 year government bond for the duration of its term, you will receive the simple interest payment each year and your principal back at the end.
For the mathematically inclined, the formula for simple interest is:
Return = P(1+rt)
Compound interest, as we said above, is when you earn interest on your interest. Using the same example above, if you achieved a steady 5% per annum return on your €100,000 investment, after one year you would have €105,000. From here on, this is where it gets different, and over time more exciting. Because in year 2, you earn 5% on €105,000, which is €5,250, and by year 10, €7,757. The table below shows how the returns each year are larger than the prior year.
|
Year |
Balance |
Interest added |
|
1 |
105,000 |
5,000 |
|
2 |
110,250 |
5,250 |
|
3 |
115,763 |
5,513 |
|
4 |
121,551 |
5,788 |
|
5 |
127,628 |
6,078 |
|
6 |
134,010 |
6,381 |
|
7 |
140,710 |
6,700 |
|
8 |
147,746 |
7,036 |
|
9 |
155,133 |
7,387 |
|
10 |
162,889 |
7,757 |
The compound interest formula is:
Future value = P(1+r)n
Exponential growth
That innocuous last part of the formula, to the power of n is what leads to the exponential growth over time. If you graph it over a longer period of time, you can see the magic of compound interest.
As per the graph above over 30 years you can add around €180,000 in additional value compared to simple interest. That is wealth creation.
Is it a good time to start investing?
The first observation, that compound interest leads to exponential growth over time, leads to the second observation, that it is best to start early. We are sometimes asked the above question, and whilst the answer is that it depends on your specific circumstances, it is best to start early and not delay when it comes to harnessing the power of compounding growth.
Debt “…they who don’t pay it”
There is a flip side to this, and that applies if you have debt. Not all debt is bad. Most people would not be able to purchase a home to live in without borrowing a mortgage. It is important to be aware of the compounding impacts of interest on your debt. In some cases, if the interest rate on your borrowings are low, it may be more attractive to seek higher compounding returns from investments and utilise the difference to pay down debt in the future. At other times, if your cost of borrowing is high, you may be better off reducing the compounding impact by paying it back faster. As with all financial planning, it depends on your situation and you should seek advice from a financial professional, like the team at Black Swan Capital.
Patience
The graph above shows that the full impact of compound interest is not seen in the first part of your investment journey; the growth multiplies over time. Compound interest therefore, is great for your long term plans and goals.
To reap the benefits, you need to apply long term thinking so you can see the benefits accelerate year on year.
To discuss how this can apply to you, contact us at info@blackswancapital.eu and we will review your position and see how it can be harnessed to achieve your goals.
Note: all calculations and projections in this article are for illustrative purposes only and do not reflect expectations of actual returns or offers of potential returns. This does not constitute advice. Always seek personal financial planning advice specific to your circumstances.
