Compound interest: It's not magic, it's consistency

November 2024 by Ana Carrisso

What is compound interest? Several quotes – dubiously attributed to famous people, such as Albert Einstein – have become popular for referring to compound interest in the financial world as the eighth wonder or the most powerful force in the world. There are even those who talk about the magic of compound interest. But it's not magic: It is the result of the reinvestment of profits and a strategy that has been proven to work in preserving assets in the long term.

Since 2010, the National Council of Financial Supervisors has been publishing, every five years, a survey on the financial education of the Portuguese population, which usually serves as a good thermometer of the evolution of the level of financial inclusion in Portugal. The latest survey, carried out in 2020 and published in September 2021, showed that, for approximately 60% of the Portuguese population, savings continue to be a priority. However, less than half of respondents answered the question about calculating simple interest correctly (42.5%) and less than a third answered the question about compound interest correctly (31%).

A tree that bears fruit

The analogy with a fruit tree that produces seeds can be a good way to understand how compound interest rates work (the famous compounding that many fund managers refer to). Let's imagine that we planted a very special tree in our garden. It is a tree that only bears fruit once a year. Each of these fruits has seeds that, if planted, grow and give rise to new trees that bear more fruit. So, in the second year, we would have a tree with fruits that was born in the first year plus other new trees that would have been born from its seeds and that are now also bearing fruit for the first time. If we repeat this process every year, we will end up with a large orchard. Furthermore, we could give some of these fruits to our children, so that they can, in turn, plant this tree and benefit from its growth.

Compound interest works in a similar way. When we invest money (the original tree) and it generates positive returns (the fruits), if, instead of withdrawing these returns, we leave them planted together with the original capital, the following year we will not only receive interest on the original investment, but also interest on what we have already earned (the seeds that have become new trees). The beauty of compound interest is that this process generates ever-increasing growth of money over time, without the need for additional effort, which is why it is such an attractive strategy for investors with an eye on the long term.

Simple interest vs. compound interest

Another way to understand how it works, this time with numbers, is to compare the notions of simple interest and compound interest. To begin with, simple interest is always calculated on the same amount invested, meaning it will never generate new interest. For example, for an investor who has a capital of 1,000 euros that he invests with an annual return of 10% per year, at the end of that year he will have obtained a profit of 100 euros, which he withdraws to spend. If the following year you invest those 1,000 euros again with a return of 10%, at the end of that period you will again have a profit of 100 euros, and so on.

But, if instead of spending those 100 euros, the investor had left them in the account with the rest of the invested capital, it could start generating compound interest. So, instead of investing 1,000 euros, in the second year you would start with an initial investment of 1,100 euros, and at the end of that year, the 10% return on capital would generate a higher profit of 110 euros.

Legendary investor Warren Buffett once said: “You don't have to do extraordinary things to get extraordinary results.” If there is something magical about compound interest, perhaps it is this: There is no need to make large trades or turn the market upside down in search of the perfect asset. You just need to be consistent and have a long-term vision to reap the rewards.