For lesser minds, this can be summarised as signifying that, early on in your life, investment years are worth a great deal more than they are later on. The astonishing implications of compound interest are so far- reaching that it is not surprising that your maths teacher wished to gloss over the whole affair.
In maths textbooks, interest in general is always looked at in terms of debt: Johnny buys a motorbike and borrows X amount of money at Y rate of interest to be repaid over Z years. How much must he repay in total?
We find questions of this sort tedious and terrifying, and it is only natural to want to shy away from the the subject as much as possible.
But there is no magic to compound interest, merely a few basic principles which we shall examine as we progress. The mathematical knowledge required for full participation in this compounding extravaganza is so minimal as to be derisory.
The first law of compounding
Start early, Fool.
Fay, a Foolish young woman of 20, decides to save pounds 100 per month from her secretarial salary. She puts this in an investment plan which gives an average return of 14 per cent on her money (we'll talk about how to get this sort of return in a later article). She carries on paying in throughout her twenties. At the age of 30 she meets Ferdinand. Shortly after this meeting, Fay decides to stop working and bring up the children.
She stops contributing to the investment plan, but Ferdinand starts to pay pounds 100 a month, into it - which he continues until the age of 60. So, the numbers look like this:
Extraordinary isn't it ? By the age of 60, Fay is almost three times ahead of Ferdinand, even though she has not contributed anything for 30 years.
The second law of compounding
Small differences matter.
Differences in investment return matter far, far more than the uninitiated could possibly think. Two to three per cent does not sound like it could matter very much, but it does.
Take Fennella, who laboured under the sad misapprehension that the building society was the place to save her hard-earned cash. Poor old Fennella entered retirement ill-prepared for what was to come. She earned 5 per cent on her investments and found herself with little more to live on than the state old age pension. She saved pounds 100 a month for forty years and this had become pounds 152,208 at retirement.
Compare that with Felicity who earned 8 per cent on the same savings. She had pounds 335,737 at retirement.
This is what happens to those who put all their faith in the building society.
The third law of compounding
Don't squander your inheritance on sex, drugs and rock 'n' roll (unless you want to).
The fourth law of compounding
Over time, regular saving of quite small amounts can build up to an astonishing sum of money.
A pounds 100 a month investment, which makes 12 per cent a year, builds up to more than one million pounds over 40 years.
The fifth law of compounding
Time and patience are the friends of compounding and, therefore, of investing.
We hope that with the Foolish Laws of Compounding rattling around in your head, you are starting to settle into the mindset of Foolish investing. Maybe you are starting to dream, to realise that you do not need a huge sum of money to begin profitably investing for the future. In short, you're limbering up for what is to come. The key to successful investing is regular saving and keeping your investment objectives in mind.
Next week: sort out your finances.
Extracted from the 'Motley Fool Investment Guide' by David Berger with David and Tom Gardner, published by Boxtree at pounds 12.99. David Berger, David and Tom Gardner 1998. To order a copy with free postage call 0181- 324 5522.
You can find out more about the Motley Fool on the web at www.fool.co.uk
the rule of 72
This is a labour-saving convenience aid to modern living. The rule of 72 allows you to estimate with a fair degree of accuracy how long it will take your lump sum investment to double at a given rate of interest. And it's simple: divide 72 by the rate of interest and you have approximately the number of years until you double your money.
72/x%=years to doubling.
Like any rule of thumb this one has its limitations and it's increasingly inaccurate once you get much above 15 per cent. (But if your investments are making more than 15 per cent a year then minor errors are irrelevant anyway.)
Here's an example: pounds 10,000 invested at 11.4 per cent will take 6.3 years to double.
The miracle of compound interest: the second extract from the Motley Fool investment guide
Fay (pounds 100pm, Ferdinand (pounds 100pm,
aged 20-30) aged 30-60)
Age 20 0 0
Age 30 pounds 26,453 0
Age 40 pounds 98,069 pounds 26,453
Age 50 pounds 363,562 pounds 124,522
Age 60 pounds 1,347,806 pounds 488,804Reuse content