I bet you’ve heard of this question somewhere else before, but I’m going to ask you anyway: If you were given the choice to choose between the 2 options as below, which would you choose?

1. 1 million dollars now.
2. 1 penny which could double itself every day for the next 30 days.

If you have chosen the former… I’m sorry about your choice, but let’s not worry about that. This post is written for you!

If you have chosen the latter… Congratulations! Though you should’ve already known what’s this post is about, I encourage you to read on.

Why you should’ve chosen the magical penny? See table below:

Day 1	$0.01
Day 2	$0.02
Day 3	$0.04
Day 4	$0.08
Day 5	$0.16
Day 6	$0.32
Day 7	$0.64
Day 8	$1.28
Day 9	$2.56
Day 10	$5.12
Day 11	$10.24
Day 12	$20.48
Day 13	$40.96
Day 14	$81.92
Day 15	$163.84
Day 16	$327.68
Day 17	$655.36
Day 18	$1,310.72
Day 19	$2,621.44
Day 20	$5,242.88
Day 21	$10,485.76
Day 22	$20,971.52
Day 23	$41,943.04
Day 24	$83,886.08
Day 25	$167,772.16
Day 26	$335,544.32
Day 27	$671,088.64
Day 28	$1,342,177.28
Day 29	$2,684,354.56
Day 30	$5,368,709.12

The Wonders of Compound Interest

Famously regarded as mankind’s greatest invention, and “8^th Wonder of the World” by world-renown theoretical physicist Albert Einstein, compound interest is one of the most important terms that we need to understand. One of the most successful investors in the world – Warren Buffett was also quoted crediting his wealth to compound interest. In his interview with Christiane Amanpour from ABC News on 28^th November 2010, Buffett said: “My wealth has come from a combination of living in America, some lucky genes, and compound interest. (Both) my children and I won what I call the ovarian lottery.” (I have written about “The Ovarian Lottery” in another post)

“Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t… pays it.

Albert Einstein

Why is it that at 1st glance, we are more tempted to choose Option 1? It’s because:

1. We crave immediate gratification. Why wait for 30 days when you can have 1 million now?
2. We, humans, tend to think linearly. We can hardly grasp how exponential systems work.

Okay, so I’m guessing some of you would say: “Hey, there is no penny in the world that could double itself every day!” Well yeah, you’re right… but let’s focus on the effect compounding here. Let’s put some real-life values to the test.

Let’s say you put $1000.00 in some investment vehicle that could generate on average 8% interest yearly. In the 1st year, your money will sprout little money saplings, giving you a measly increment to $1,080.00. Well, that doesn’t sound like fun, with only $80.00 gains after a whole long year. In year 5, it grows to $1,469.33. Well, that’s not too bad, almost 50% growth. Leave it there for 10 years, and it grows to $2,158.92. Basically, you’ve just doubled your money! Leave it there for an even longer period of time, say 30 years, and it’ll grow to a whopping $10,062.66 (10x of your initial investment)! You can do various calculations using compound interest calculators which are easily available online.

The example above shows the need for another key ingredient that gives life to the marvels of compounding – TIME. Without time, its effects will not be obvious. That is why many financial experts’ advice is to invest in the long term. Giving a longer time horizon will give compounding its ability to work wonders.

The Importance of Time

To illustrate how crucial time is in compounding, let’s imagine a scenario between twin brothers Nathan and Drake, both 20 years old at the time.

Nathan started investing $5,000 a year at age 20, and contributed the same amount until he hit 30.

Drake, however, didn’t start to invest until he was 30. At 30, similar to Nathan, Drake invested $5,000 a year up until age 50.

Let’s assume both brothers can achieve 8% yearly returns compounded annually.

At age 50, Nathan can reap a comfortable sum of $389,758.85. Drake, however, only managed to accumulate $265,019.39. That’s a total difference of $124,739.46! How did Nathan manage to get ahead of Drake by such a huge sum, even when he has invested a lesser amount (Total investment of $50,000 compared to Drake’s $100,000)? Nathan spent fewer years investing (10 years compared to Drake’s 20 years of investing).

You’ve guessed it – Time and compounding. Although Nathan has less amount invested, his money did spend more time in the market, giving it more time to grow. This simple example shows how important time is in the process of compounding.

The Dark Side of Compounding

Remember the earlier quote I’ve posted from Albert Einstein on compound interest? – “He who understands it, earns it… He who doesn’t… pays it.” Yes, it goes both ways. Interest on loans compounds as well.

This is the reason why should always pay our credit card dues in FULL. Paying the monthly minimum will only make your total expenditure grow, and you’ll end up paying more.

It’s the same for mortgages as well. The longer the tenure, the higher the compound effect will be. Usually, at the end of the 30-year mortgage, you’ll be paying the price of 2 houses instead of 1. Well, this can hardly be avoided as it’s very uncommon for people to purchase a house upright with cash (unless you’re a crazy rich Asian).

Remember, compounding is a double-edged sword. Use it to your advantage.

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This is post #3.

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