Ask An Adviser - What Is Compound Interest And Why Is It Good? (1)

Top answer provided by:

Robert Goudie

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Albert Einstein, once said that “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”. 

 

Compound interest is also the primary reason behind the accumulation of vast wealth by many of the world’s most successful investors, including Warren Buffett.

 

Warren Buffett’s company, Berkshire Hathaway, is a classic example of the effect of compound interest, given that it has not paid a dividend to its shareholders in the last 57 years. Berkshire Hathaway’s profits have been reinvested back into the business to purchase more investments, which in turn, generate more profits for the business ready to be reinvested. This is essentially compound interest at work, which in simple terms can be described as “earning interest on your interest”.

 

As a simple example, let’s take a $100 investment earning 5% interest per year. At the end of year one you have earnt $5, which instead of being taken by the investor and spent, it has been reinvested. At the start of year two you have $105. Let’s assume for year 2 you earn 5%, that interest rate is applied to the $105 earning you $5.25 which again is reinvested. Rinse and repeat over decades and the results are life changing.

 

Whilst I could keep going with the example, no doubt you’ve got the gist. Compound interest is a sure way that you will grow wealth, very slowly, over the long term.

 

Your superannuation funds are a classic example of compound interest at work, which combined with your superannuation contributions is compounding its way to retirement.

 

It is also worth remembering Einstein’s quote above, as it is also referring to those with too much debt. Compound interest can work in reverse and can be the primary reason some people never achieve financial independence.

 

Kind regards,

 

Rob

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Article by:

Rob Goudie

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