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Compound Interest Definition

Compound Interest Definition

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Reading Time: 4 minutes

Reading Time: 4 minutes

Receiving interest on interest, or: Compound interest. It is the magic recipe for wealth achieved by investors through long-term investing. This concept, which explains the importance of starting to invest early, is an essential pillar of buy and hold investing – one of the most popular investment strategies. But how does compound interest work and why is it often seen as the key to wealth?

General Idea of Compound Interest

To keep it simple, we will use a metaphorical comparison to which everyone can relate – the Corona pandemic. Although the exact origin of the virus is still unknown, let us assume that initially only one person was infected. But how can a single infected person trigger a global pandemic? The explanation is quite simple: The rate of infection is exponential. This exponential growth is also what makes compound interest so powerful. The idea is to (regularly) save money and to get interest as well as interest on that interest in subsequent years. In times of low interest rates, you can also apply this concept to the stock market by reinvesting dividends. In the long run, you will not only generate passive income through dividends, but also price gains. It is common for wealth accumulation to proceed slowly at first. However, thanks to exponential growth, investors will be rewarded sooner or later.

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Case Study: The Power of Compound Interest

Illustration 1: Compound Interest Comparison
This illustration above demonstrates the power of compound interest by comparing three alternative investment concepts. The black line shows the (slow) accumulation of wealth through cash savings ($ 500 per month) with no return. After 50 years, cash savers will generate $ 300,000 in cash. The red line shows how the situation will change if the money is used to invest in the stock market instead – assuming a 7 % annual return (dividends and price gains less trading fees) without reinvestment. In this case, investors will build up a portfolio worth more than $ 800,000 in 50 years. Those who go one step further by using their returns for reinvestment (blue line) will even achieve almost $ 2.5 million (!) after 50 years. Unlike the black and red lines, the blue line rises exponentially rather than linearly – making all the difference in the long run.

Limitations to our Case Study

We want to point out some limitations to our case study. First, we are assuming a monthly savings rate of $ 500 and an annual return of 7 %. Case studies require fixed parameters. But, in real life, those parameters may change as investors are having different investment opportunities and stock markets do not rise on a straight line. Furthermore, our case study does not take into account the inflation rate. The inflation rate can negatively affect the real worth of future savings as prices of goods and services rise over time. Nevertheless, we are convinced that our case study clearly demonstrates the power of Compound Interest and makes it clear to everyone that investments are particularly worthwhile starting from a young age.

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