Albert Einstein is reputed to have described compound interest as “the most powerful force in the universe” and “the greatest invention in human history.” Whether he did or didn’t use these phrases, capitalizing on the positive attributes of compound interest is a very important part of any wealth-building strategy.
Investopedia defines compound interest as interest calculated on the initial principal, which includes all of the accumulated interest of previous periods of a deposit or loan. In effect, compound interest is interest on interest, and will make a sum grow at a faster rate than simple interest.
The so-called “Rule of 72,” calculates the approximate time over which an investment will double at a given rate of return, based on annual compounding. For example, an investment that has a 6% annual rate of return will double in 12 years. An assumed rate of return of 8% doubles in nine years.
The concept of compound interest is particularly useful in looking at the potential long term returns on equity portfolios. While annual rates of return can vary significantly for equity investments, calculating the expected average annual rate of return, and applying the “Rule of 72,” can provide investors with some insight as to the potential long term value of their portfolios.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA