Sunday, October 17, 2010

The Miracle of Compound Interest

One of the most memorable quotes of Albert Einstein was that "the most powerful force in the universe is compound interest!" Compound interest is really the catalyst that expands your funds and it's the mechanism that can turn small savings into huge sums. With a decent return on your investments (6-8%) and patience, compound interest can grow your savings astronomically.

Here's an awesome story that beautifully illustrates the power of compound interest. Back in the early history of China there was an emperor who had great problems with their tax laws and trouble calculating the dynasty's cash reserves. To solve this problem he hired one of the most prominent mathematician's at the time. The mathematician toiled day and night trying to audit the financial books of the dynasty and finally after months of slaving had solved the emperor's cash reserve problem thus saving the dynasty from financial ruin.

To reward the mathematician the emperor was willing to grant the mathematician whatever he wished, as long as the emperor approved. The mathematician thought long and hard about this and simply asked that he would be given a dollar one day and the next day two dollars, and the next day 4 dollars and so on... for an entire month (30 days), each day doubling the amount given. The emperor in his haste granted the mathematician's wish, not understanding the power of compound interest. Although the amount initially would be small, the amounts would grow exponentially. Eventually by day 30 the amount would grow to $536,870,912! By the end the emperor had to forfeit his entire kingdom to the mathematician or face the shame of not fulfilling his promise.

This story illustrates the power of compound interest. By making small investments early on in your investment career, your savings can grow dramatically. As long as you save for the purpose of growth and reinvest your returns, you can let compound interest work for you. Compound interest is one of the best tools you can use to increase your savings for your long term goals such as retirement or your child's education fund, since one of the main requirements is time. Harness the most powerful force in the universe save often and start early!

Here is a quick video clip illustrating the power of compound interest:

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