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FINANCIAL INSIGHTS
The internet brings a wealth of financial resources to your fingertips. For money management tools, visit http://www.quicken.com.
For financial news and stock reports, point your browser to http://cnnfn.cnn.com/ or http://moneycentral.msn.com/home.asp.
You can find financial terms defined in plain English, easy to follow investing tutorials, articles and insights at http://www.investopedia.com.
Or check out http://www.bloomberg.com/ for online economics courses, breaking financial news and other tools designed for your economic well-being.
Investment features designed to Educate, Amuse and Enrich are available at http://www.fool.com
"If there really are seven wonders of the world,
then the eighth is compound interest."
Milton Freidman,
Nobel Laureate Economist
Few people realize the power of saving over time. Interest on an investment is the consideration paid to an investor for the use of their funds over time. Compound interest refers to aggregation of both principal and interest over time as successive investment periods earn interest on increasingly larger principal amounts due to the fact that interest earned during previous investment periods is added to existing principal. That may sound like a mouthful, but the concept is surprisingly simple – and the effects can be stunningly significant.
It is an often told lore in finance: Most people know that Manhattan was purchased from the American Indians. More specifically, in 1626, Peter MINUIT, a Dutchman, is said to have purchased the island for the equivalent of $24 in trade goods from the Manhattan Indians. Twenty-four bucks! For New York City? What fools! Maybe. Maybe not.
Twenty four dollars, invested in 1626 at a fairly modest 8% rate of interest, would be worth $197,948,307,461,013.00 today. That's 197 trillion, more than the assessed value of all the real estate currently in Manhattan! If you think of all the fortunes made and lost on Wall Street, all the real estate deals, the general commerce, how can this be? The answer is the time value of money.
Consider the most basic example: A $1000.00 investment for 1 year, a simple interest rate of 10% per year, no compounding. At the end of one year you would have earned exactly $100.00. Alternatively, if you invested the same $1000.00 in an investment for the same one-year period at the same simple interest rate of 10%, except this investment is compounded monthly (12 times per year), at the end of one year you would have earned exactly $104.71. Same investment – same interest rate. You may be thinking this $4.71 is chump change – and perhaps it is for a single year. But lets look at another longer-term example to see how the effects magnify over time.
Twin brothers, Mike the Miser and Sam the Spender, are each willed $10,000 by their generous old Aunt Tillie on their 18th birthday. Sam the Spender doesn’t squander his stipend, but instead places it in a one-year certificate of deposit, 10% interest rate – no compounding. Sammy wisely decides not to touch the principal and instead spends the $1000.00 dollars interest earned each year (in our example, for simplicity sake, interest rates remain unchanged). Mike the Miser, on the other hand, decides Aunt Tillie's stipend is found money and he chooses to invest it and not spend any of the principal OR the earnings. He invests his $10,000.00 in a one-year certificate of deposit, same 10% interest rate as his brother, compounded quarterly. At a barbecue to celebrate their 28th birthday, Sam is astonished to learn his brother’s investment has grown to nearly three times its initial value - $26,850.64. Mike wisely advises his twin brother to check out an investment that compounds his earnings – and over the next few years Sam really means to – but somewhere in the hustle and bustle of every day life Sam neglects to – and even forgets about it – until ten years later – another barbecue. This one to celebrate the high school graduation of Sam’s daughter and Mike’s son, both born 4 weeks apart. Mike queries his brother, "Did you ever check out an investment that compounds??". "Never got to it," Sam confesses, "but how big a difference could it make?? I’m earning the same 10% as you!" "Well my investment is now worth over 72 grand ($72,095.68 to be exact)," Mike advises. Impossible, Sam thinks, and begins to doubt his brother’s sincerity, or at least his math skills. They never discuss Aunt Tillie’s gift again – until 27 years later. Both families are big on barbecues and this barbecue is to celebrate the long deserved retirement of both twin brothers. Both healthy at age 65, the two had similar careers with comparable earnings history. In discussing their retirement plans, Sam confides he hopes his Social Secuity income coupled with his modest pension will allow he and his wife to keep their home. It would be tight, but they would try. Mike is slightly embarrassed to share with his brother his retirement plans that include the recent purchase of a 50-foot Carver touring yacht. "Yacht!", Sam exclaims, "you don’t know how to pilot a Yacht!" "Of course not," Mike concedes, "which is why I had to hire a captain." At this point Sam is certain some yet-to-be learned fate such as a lucky lottery ticket must have befallen his suddenly prosperous brother. "How can you afford all that?," Sam snaps at his brother. "Didn’t you ever follow my advice in regard to Aunt Tillie's gift?," Mike asks for the last time. Although Sam still had the original $10,000 left to him more than 47 years ago, it is with something just short of disbelief that Sam learns in the ensuing conversation that Mike’s $10,000 is now worth more than 1 million dollars ($1,037,735.55 to be exact). The barbecue ends and each brother and their wives depart for their respective, and very different, retirements. On the drive home Sam can’t help but taste just a hint of sour grapes still not believing his perceived misfortune. Even though Sam withdrew $1,000 each year for 47 years, that now sure seemed to pale in comparison to what his brother had accumulated. Still refusing to believe the cold hard reality, Sam is sure that somehow, Aunt Tillie must have been more generous to his brother. After all, he muses, Aunt Tillie always liked Mike better.
In truth, Aunt Tillie loved both nephews the same. About that, Sam was wrong….but, of course, Milton Freidman is right.
This financial lesson can be a hard one learned, and the earlier in life you learn it the better off you will be.
Chief Operating Officer
Executive Vice President
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