Opinion and Investing Column

KIM: Compounding, Rule of 72 work for you if you let them

July 7, 2012

KimSaving/investing more and earlier is a simplistic strategy, but it requires discipline, patience and hard work. Still, this approach is more fruitful and less frustrating than the perpetual chase of the “perfect” investment that will make us rich overnight.

Albert Einstein is said to have called compound interest “the greatest mathematical discovery of all time,” “the most powerful force in the universe,” and “the eighth wonder of the world.” He wasn’t an investment guru, but clearly understood compound interest is a powerful lever that can make your financial life better. Or it can kill you.

Whether the quotes are accurate is beside the point. Compound interest is a powerful lever that can make your financial life better. Or it can kill you.

How does compounding work? For simplicity, let’s assume you start with $100 and earn 8 percent on your investment, compounded annually. After year one, you have $108 (the original $100 investment plus 8 percent interest earned on it). After year two, you have $117 (the $108 you had at the start of the year plus 8 percent earned on that). After year three, you have $126 (the $117 you had plus 8 percent earned on that), and so on.

Left undisturbed, your original $100 investment will have grown to $200 after year nine. This happens because each year you earn interest on your original investment and on all of the accumulated interest (i.e. interest on interest).

Meet Mary and Larry. Now the same age, they both invested $10,000 and earned the same 8 percent, compounded annually. The only difference (and it’s a big one) is that Mary made the investment when she was 24, but Larry didn’t get around to it until he was 33. By the time they were 42, Mary had $40,000, but Larry had only $20,000. At 51, Mary had $80,000 and Larry $40,000. By the time they were 60, Mary had $160,000 and Larry $80,000.

The gap between Mary and Larry widened from $20,000 at 42 to $40,000 at 51 to $80,000 at 60, just from compounding. Even though they invested the same amount and earned the same return, Mary’s account had the huge benefit of compounding for nine years more than Larry’s.

Enter the Rule of 72, which investors love. Simply divide 72 by your assumed interest rate/rate of return to get the number of years it takes to double your investment. At 6 percent, it takes 12 years. At 8 percent, it takes nine years.

Whatever your return assumption, it’s better to start sooner rather than later. You want to let compounding work as long as possible for you.

The corollary is that credit card companies love the Rule of 72 even more than investors. Why’s that? Because the interest rate they charge dwarfs the returns investors/savers can earn. Instead of 6-percent to 8-percent returns, you’re probably talking about at least 18-percent interest on outstanding balances.

Disregarding the minimum monthly payment and assuming no further purchases, at 18 percent your credit card debt will double every four years (72 divided by 18). You can see how credit card debt can get out of control in a hurry.

Compound interest and the Rule of 72 can be tremendous financial levers to help you accumulate assets. They can also crush you. Save/invest sooner and more and avoid credit card debt like the plague.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
 

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