The Compound Effect

 

Albert Einstein is said to have said that the compound effect is the eighth wonder of the world. I am prepared to agree, but what is the compound effect and why is it classified as a miracle?

 

By Viktor, co-founder of Bifrost - Jan 28 2019

The Compound effect

I shall illustrate this with a calculation example.

Imagine you have £1000 in a savings account, you get 10% interest on your money annually (impossible in practice at present as the highest interest rate the banks offer on savings accounts is about a few percents, but it will be easy and clear in the example). You will keep the money in the savings account for 10 years and the interest rate during these years will be a constant 10%.

How much money do you have after 10 years? Anyone who is not familiar the compound effect would probably have answered £2000. Because 10% of £1000 is £100, and that times 10 years gives us £1000 + £1000 = £2000.

But this is not how it works in real life. The actual result would have been:

 

Year 1 £1000 * 1.10 = £1100     Yield: £100

Year 2 £1100 * 1.10 = £1210     Yield: £110

Year 3 £1210 * 1.10 = £1331     Yield: £121

 

Thus, the interest rate we get increases for each year, and it also increases faster and faster because the amount that is being repaid each year becomes larger. And after 10 years the sum would have grown to £2594. (£1000 * 1.1 ^ 10)

This is a considerably higher sum than you probably imagined, and if we had saved the money for another 10 years, the sum would instead have been: £6727 (£1000 * 1.1 ^ 20). This is why you can call the compound effect for the world's eighth wonder. Every year, it increases faster and faster. The 21st year gives them 10% us £673, which is almost 7 times as much as year 1. Now try to figure out for yourself what the money would have grown to if we kept them for another 10 years (1000 * 1.1 ^ 30).

 

So, with this knowledge, don't let your money be unemployed. Put them to work and let the compound effect help you reach your goals and fulfill your dreams. Though, putting money to work and using the compound effect can be done in more ways than through a savings account. You can, among other things, buy shares or funds if you are prepared to take a risk with your money, this can also generate a higher return because we know that risk and return always go hand in hand. As explained in the previous blog post about Investment and Risk.