Compound Interest: The 8th Wonder of the World

Probably, there are some of us who are still wondering about the concept behind compound interest. In this article, I would like to explain further about compound interest: The 8th wonder of the world.

The concept of compound interest was initiated by Albert Einstein. According to Einstein, “He who understands it, earns it. He who does not, pays it”. What does it mean? Let me give you an example: Let’s say you have a credit card bill amounting to IDR 5 million, and from that bill you only pay the minimum amount IDR 500k. You might think, “Oh, isn’t it good for me that from IDR 5 mil, I only need to pay 10% of it”. In the end, the remaining IDR 4.5 million will generate interest and as time goes on, your credit card payable will become bigger & bigger without you realize it.

On the other hand, for you who understand how compound interest works, might take huge advantage of it. One of the ways to take advantage from it is through investment instrument. To help you understand the compound interest concept, I will give you an illustration:

Try to answer this question in 3 seconds. Please choose only one from these choices:

1.????? You will receive IDR 10 billion from me TODAY

2.????? You will receive IDR 100 from me today but this IDR 100 will multiply by 2x every day for the next 30 days

My guess, most of the respondents might choose option 1. However, is option 1 the correct one? Let us see the picture below:

If you see from the first 10 days, the difference is very far: IDR 10 billion vs IDR 102,400. Now check the picture below:

Here, things are starting to become more interesting: look at day 19 & 20, we can start to identify significant improvement from IDR 52.4 mil to IDR 104.8 mil. On the day 21-30 are when the moment of truth comes:

By day 27, our IDR 100 has finally surpassed the IDR 10 billion and become IDR 13.4 billion. Ultimately, on the final day (day 30), the IDR 100 has become IDR 107.3 billion! So, we can see from day 27-day 30, our IDR 100 has outgrown the IDR 10 billion completely. Now the question is: how is the relationship of the compound interest concept with investment? Of course, it is IMPOSSIBLE for our money to grow by 2x every day. In its relationship with investment, the compound interest will very much help us in our investment journey. For instance, imagine that you invest in something (stock) with conservative annual return around 15%. However, please take a note that every year, you cannot withdraw the 15% return.

To give you simulation for this, keep in mind that we start our investment journey with IDR 10 million (still with assumption that per year, we will get 15% return & we cannot withdraw it). Check the illustration below:

By the end of year 5, our IDR 10 million has become IDR 20.1 million. The interesting thing is, in year 1, the return that we get are IDR 1.5 million. However, in year 5, the return that we get are IDR 2.6 million (around 73% higher!). Remember, this is only in 5 years, what if I lengthen the period to 30 years? This is the result:

In year 10, our IDR 10 million has grown to IDR 40.4 million. In year 15, IDR 81.3 million. In year 20, IDR 163.6 million. In year 25, IDR 329.1 million. Finally, in year 30, IDR 662.1 million. Is that all? Not yet buddy, this is the result if we only deposit once in year 1, and throughout the remaining 29 years, we no longer add the deposit amount. Now, what if we add IDR 10 million every year (until year 10) to the investment amount? So, in year 2 we add another IDR 10 mil, in year 3 we also add another IDR 10 mil, and so on and so forth until year 10 (or in other words, we add around IDR 833 thousand per month. However, to simplify the illustration, let us just use IDR 10 million per year). This is the result:

As you can see on the figure above, if we add another IDR 10 million every year until Year 10, our final investment amount by the end of year 30 will be IDR 3.8 billion (~5.77x higher than before). Not bad huh? Is it enough? Not so fast folks. That is the result if we can save IDR 10 million per year, what if we save more? Let say you get salary increment/ additional revenue stream from your side hustle so you can save IDR 15 million/year or IDR 20 mil/year or even IDR 30 mil/year (amen to that!), and so on. Furthermore, that is also if we use 15%/annum return rate, which is conservative enough. What if we can get more than 15% since you already have more knowledge in investing? And finally, this is also if we assume only to invest for 30 years. What if we can add more years to our investment journey until we are getting old? Let’s say if currently you are 20 years old. Today, Warren Buffet is 93 years old, and he is still as fit as ever (and I pray for him to always be healthy!). It means that your investment period might be not only 30 years, but can be up to 60-70+ years! Can you imagine how much money that you can yield from your investment? From the figures above, you can try by yourself to calculate how much further your investment will grow if you change some variables such as annual return rate, investment period (how old you are now), and how much money you can save per year/month.

Additionally, I have some tips so that this compound interest can work optimally to your investment saving. I would like to describe these tips as 3 main pillars:

1.????? Investment rate. This is the % of money that you can invest/save from your total income. For example, imagine today you have a salary amounting to IDR 5 million/month, and you can invest around IDR 1 mil. It means that your investment rate is 20%. Imagine if in the future your salary increases to IDR 10 mil/month, and you can save IDR 3 mil/month, it means that your investment rate increase to 30%

2.????? Return. Let’s say currently you are still beginner and don’t have the guts/knowledge yet to put your money in stock market. Instead, you are willing only to put your money in an instrument that has almost 0% risk (e.g obligation), that is okay though. But, to generate higher return, you must invest in yourself first! For example, buy investment books, join an investment seminar, find a right/proper investment mentor, pursue higher degree, etc2

3.????? Time. The longer your investment timeframe is, the more powerful the compound interest effect is. You just saw on the figures above, maybe throughout year 1-5 we can’t really see yet the investment result. However, once it reaches year 10,15,20,30 and so on, the power of the compound interest will become ridiculously powerful.

In the context of stock investment, somebody asked me, “For this compound interest to really work, does it mean if I buy a same stock should I never sell it or I can sell it or how?”. The answer is depending on the context:

1.????? For the first option, the compound interest concept will greatly match if you buy a core stock. So, you buy a stock, and hold it for a very long time, and never sell it. The dividend that you get from this stock, should be re-invested again to the same stock

2.????? However, there is a weakness from compound interest concept: you cannot use it for all types of stock. For instance, in cyclical stock (commodity, shipping, etc.)/ a company stock where its financial performance is declining. Why? Because if your hypothesis/ investment thesis is wrong, and you hold that stock forever, and turns out that the stock price is not going anywhere/even declining, or the company does not pay dividend, then we will lose the time (opportunity cost). Hence you need to see case by case, which kind of stock are you going to invest in. Do your own research, do your homework!

For me personally, I prefer to recommend you to buy value stock (undervalued stock). What is value stock? Value stock is a stock that is being mispriced by the market, and usually, its margin of safety is high. Once you buy value stock, give it time. Perhaps, more or less 1-3 years. And when the stock is reaching its intrinsic value, it is okay if you want to take the profit/sell the stock. The capital gain & dividend that you get from that stock during the period, you can re-invest it again to the other value stocks.?

In summary, I feel it myself that this compound interest thing is working magnificently in my investment journey so far. My suggestion to you, start invest as early as possible because investment needs time, and do not feel inferior if you think that your fund is not big yet. Small fund is not a problem. By taking advantage of compound interest, your small fund might get bigger & bigger every year (snowball effect). There is a proverb that says: “Do not wait to be rich to start invest, but invest first and then you will become rich”. Lastly, possess a right skill & mindset, and invest more to yourself (knowledge, degree, etc.).

Happy Investing! Happy Cuan!