$BTC Compound interest is one of the most important concepts in investing, and it is also a crucial algorithm in life.
What is called compound interest is the interest that accumulates on interest; it is also known as 'the donkey rolling in the dirt' in folk terms; you might have heard the magical power of compound interest a thousand times from online books.
Compound interest is so important that Einstein said it is the eighth wonder of the world and the greatest force in the universe.
But please note, this account is neither a traffic account nor a motivational account; I hope you can gain some true insights about compound interest after reading this article.
The magical compound interest you see is all a deception.
1. The magical chicken soup of compound interest
The chicken soup about compound interest that you have read usually starts like this:
In the 17th century, a Dutchman bought Manhattan Island from the Native Americans with $24 worth of fabric and jewelry.
Manhattan Island is now the most prosperous commercial center in the world, conservatively valued at $25 trillion.
Now, at first glance, you might think this Dutchman's deal is an unbeatable profit, going from $24 to $25 trillion.
Don't rush; let's see how much that $24 would have turned into if he had invested it back then, following our teacher's guidance for proper financial management, calculating based on the average investment return rate of 9% in the U.S. stock market over nearly 100 years.
From 1626 to 2000, after more than 300 years, according to a 9% investment return rate, this $24 would miraculously turn into $23.86 trillion, enough to buy about 1,000 Manhattan Islands!
Of course, these are all foreign stories; we have simplified versions in China.
1.01^365 = 37.78
0.99^365 = 0.026
Improving just a little every day can lead to astonishing progress over a year, while a slight decline each day can leave you with almost nothing by the end of the year. Isn't the result very motivational? Indeed, the power of compound interest is truly remarkable.
If you still find it not stimulating enough, I have something even more impressive to show you:
1.01^1000 = 20959.15
0.99^1000 = 0.000043
But unfortunately, what you see is just chicken soup.
In the story of Manhattan Island, there was no stock market in 1626.
Even if there are, who can guarantee a stable annualized 9%? For 300 consecutive years? The world's number one, the United States, has barely over two hundred years of history.
Let's consider the Chinese version of the calculation problem: if you improve a little every day, by the end of the year, you would be 37 times better than your past self? That's amazing; aren't you going to heaven already, brother?
At the beginning of the year, the salary is $10,000; are you going to tell your boss at the end of the year: Boss, I'm getting better every day; my monthly salary should be $370,000?
2. The most important formula in life
Although the motivational stories about compound interest might sound very silly upon reflection, the formula for compound interest is a very important model in our life algorithm.
Compound Interest = Principal Ă (1 + Rate)^Time
If you thoroughly understand the three elements of compound interest, your direction of effort will become clear.
(1) Principal
Letâs first talk about the principal.
You often see in melodramatic TV shows a poor male lead saying to the rich second-generation antagonist: Being rich is impressive!
Wake up, my friend; having enough principal in the real world is indeed very important.
You may have heard that with a 10% compound interest, the principal can double in 7 years.
(1 + 10%)^7 â 2
What if you don't use the logic of compound interest? If you just leave the principal there and calculate using simple interest, at 10% each year for 7 years, that would still be 70%, which isn't too far from 100%.
So do not overly attribute all the results to interest on interest; over a period of 7 years, most of your earnings still come from the basic interest on your principal, not from compound interest.
Having enough principal is truly important.
Many people often forget the importance of principal; its increase determines the height of future assets, but the increase in principal isnât something that financial management can bring; it requires you to continuously work hard to acquire from the outside.
Currently, all kinds of ridiculous financial training available on the market fail because they only tell you about the importance of compound interest, but never mention that the little principal you have doesnât yield much through compound interest.
(2) Time
Why can't you ask your boss for a monthly salary of $370,000?
Because the idea of 'improving 1% each day for a year' is extremely unreasonable.
You might say, can I memorize 5 more words than yesterday every day? That's not hard, right?
Sorry, this is linear addition, not compound interest. Moreover, not only is it not compound interest, but the more you memorize, the more you forget.
Anyone who trades stocks knows that a 1% increase in net worth in one day is quite easy, but who can maintain a 1% increase every day for a year?
The idea of 365 times is indeed a beautiful imagination, but unfortunately, it does not exist in real life.
A more reasonable calculation should be done using 'years' as the unit. You will find that to reach 365 times, you would roughly need ten lifetimes to ask your boss for 370,000.
Don't dismiss it as slow; the essence of compound interest is precisely that it never tells you to achieve rapid success or to increase 37 times in a year.
Let's look at the example of Warren Buffett; the following chart shows Buffett's asset growth curve:
This curve also aligns very well with the compound interest curve mentioned above, initially inconspicuous, then rapidly ascending. In other words, the vast majority of Buffettâs enormous wealth was earned after he turned 50.
In other words, even someone as remarkable as Buffett did not have much wealth before he turned 50.
In other words, ordinary people like us do not have such a high rate of return, and it is likely that we will grow at a slower rate than his compound interest.
Therefore, if you truly believe in the compound interest growth curve, you should accept a reality: becoming rich takes time.
This gradual process may take three years, five years, or more likely, ten or twenty years of persistent effort without slack.
(3) Rate of Return
When we create any compound interest growth curve, we always assume a growth rate of 10% or 15%.
However, in the real world, not only can you not find a 20% interest rate, but you also cannot find a 15% interest rate, and you can't even find a 10% interest rate.
You might have seen countless folk stock gods claiming to multiply their investment by five times in a year. But you should know that many can achieve five times in a year, but few can double their investment in five years.
If any investment company on Wall Street claims to guarantee a 10% interest rate, countless people would cry and hand over their funds for management.
In the real world, only illegal fundraising companies like Ponzi schemes dare to make such guarantees of perpetual growth.
In other words, very few things exist in the real world that exhibit long-term exponential growth.
The growth in the real world often follows an S curve.
The chart below shows the growth of mobile phone users worldwide, which is a typical S curve.
You can find many examples in life that satisfy such an S curve, such as your proficiency in practicing a new skill, or the global user count of WeChat, and so on.
Speaking of this, you can also understand why our GDP grew rapidly after the reform and opening up, but the growth rate has recently declined; it cannot always maintain an annualized growth of over ten percent (if we had 20% annualized growth, it wouldnât take long for us to dominate the world).
Consistently stable compound interest exists only in imagination.
So I say, those who pin their hopes of getting rich on compound interest, calculating how much this interest rate can theoretically bring in 30 or 50 years, are lazy in their cognition.
When the S curve reaches a bottleneck, what we need is innovation, breakthroughs, and cognitive upgrades to continue maintaining growth.
The real world is complex; all we can do is continuously learn and grow personally to keep raising the growth of this compound interest curve.
For us as individuals, once our cognition falls behind, it is not just a simple halt in growth; the more terrifying thing is that the curve turns downward. You must know that no matter how much money we earn, losing all the principal only requires 100%.
Finally, let me tell you a toxic motivational story about compound interest:
"Stop smoking so much; if you quit now, the money saved over 15 years, compounded, could buy a BMW!"
"Do you smoke?"
"I never smoke."
"Well then, please bring out your BMW~"
Socrates once said that a life without thought is not worth living.
The most interesting part of investing is its counterintuitive nature, so all the concepts in your mind need to be reworked, and the knowledge you encounter needs to be filtered through your own cognitive system.
According to investigations, Einstein never actually said anything like 'compound interest is the most powerful force in the universe.'
