Understanding the concept of compound interest is crucial, but our minds struggle to comprehend the exponential growth of compounded returns, which leads people to mismanage their investments and debt.
The principle of compounding is relatively straightforward: you earn interest on your initial investment (the principal), and then you earn interest on the interest. But it's not just about interest. This concept applies to any returns on investment, including dividends or capital gains. It's the mathematical equivalent of a snowball rolling downhill, gathering more and more snow as it goes.
So why do many people underestimate the power of compounding? It comes down to how our brains are wired. Humans evolved to think linearly, not exponentially. In the wild, most of the relationships we encounter are linear. If you walk twice as long, you get twice as far. If you wait twice as long for your prey, you get twice as hungry.
This linear thinking doesn't translate well when it comes to understanding exponential growth. For example, if you fold a standard sheet of paper 50 times (assuming you could), it would reach from here to the sun. This is counterintuitive because our brains are not naturally equipped to handle exponential growth.
This cognitive bias often leads to underinvestment. People tend to invest with a linear perspective, thinking that double the investment means double the returns. But with compounding, double the investment can lead to significantly more than double the returns, especially over long periods.
Time is the secret ingredient in the recipe of compounding. The longer you leave your investment to grow, the more profound the compounding effect becomes. This is why financial advisors constantly stress the importance of starting to invest early.
To help comprehend compounding's full effect, consider this example. If you invest £1,000 at an annual return rate of 10%, you'll have:
<aside> <img src="/icons/chart-line_purple.svg" alt="/icons/chart-line_purple.svg" width="40px" /> Your money doubles every 7 years, and this is how most people can retire as a millionaire by investing early.
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On the other hand, keeping £1,000 debt at a 20% interest rate means you’ll be negative: