The power of compound interest and the rule of 72

Einstein famously once said, "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it". And he's right, of course. The beauty of compound interest is that it earns interest on your interest. So, once you've made a lump sum to invest, your money can start doing all the hard work for you. 

The ability to grow your investment capital by earning interest on your interest is the main benefit of a long-term investment approach. But this principle doesn't just apply to interest. The same philosophy can be applied to dividends paid by companies and distributions allocated from managed funds such as the Clearwater Dynamic Portfolio and DMG Diversified Portfolio.

The idea is that if you don't touch your earnings and let the money you've made be reinvested, you'll benefit from compound interest. And that means your investment will grow at a much faster rate.

But how much faster?

Well, there's a popular formula you can use to find out. 

It's easy to wrap your head around, and it's called the rule of 72. Apply this formula to your initial investment figure, and you'll discover how many years it will take to double your investment. All you need to do is apply some simple mental arithmetic.

Here's how it works. 

Think of the rate of return you feel is reasonable on your initial investment. Let's say 8% is your magic number.

Next, drop off the percentage sign, which leaves you with 8.

Then divide 8 into 72, which equals 9.

9 represents the number of years it will take to double your money.

Or, put another way, if you earn 8% a year for 9 years, you'll double your money.

It gets more interesting when you don't touch your earnings for another 9 years because the new total doubles again. So, $10,000 becomes $20,000 after 9 years, which then becomes $40,000 at the 18-year mark.

Add a zero to the $10,000, and you can see that compound interest is an exciting way to grow your investment!

Applying this formula is fun, but it's also a helpful life tool to have on hand whenever you need it. Not only can you easily work out how long it will take to double your money. But you can also work out how your investment could be affected by falling interest rates or increasing inflation.

What's more, the rule of 72 clearly illustrates the limitations of leaving your money to grow in term deposit accounts. At the current interest rate of say 1%, that means it would take 72 very long years to double your money.

This simple mathematical equation may encourage you to think about taking on more risk over the long term. If you can achieve a return of 10% a year on your investment, (a challenging task!), your money will pretty much double every 7 years.

With this in mind, you can see that our investment portfolios are designed to capture the benefits of compounding over the long term. As of last month, DMGDP's return over the year stood at 15.18%. While the return on the CDP, our higher return, higher risk fund reached 22.57% over the same period. Admittedly this was from the low point of last year but they are great results.

If you'd like to watch your money grow without lifting a finger, letting compound interest work its magic is definitely the way to go.

To find out more about investing in our portfolios, please get in touch.

by Gary Lucas.