One of my all-time favorite quotes is one attributed to Albert Einstien: “Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t, pays it.” You will probably see that quote a million more times on my blog because it is one of the truest concepts ever! Sadly, too many fail to understand and grasp it. Therefore, I’m going to give you an example to help you recognize the importance of compound interest.
“Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t, pays it.”—Albert EinstienClick to tweet
If I offered you $5000.00 cold hard cash or a magic penny that doubles its value every day for 31 days, which would you choose? Most people would choose the $5,000 because they simply want that instant gratification. However, a penny doubled every day for 31 days is just over $10 MILLION! HOLY BATMAN! That’s a lot of money.
On day 10 your penny is only worth a measly $5.12. I get it! That doesn’t seem like much when you could have taken the $5000 and run just nine days earlier. However, if you hold out until day 20 on the penny, then you have just over $5241.00. You would finally come out better than the person that chose the $5000 on day one. Compound interest is finally showing its muscles!
Now, let’s take our magic penny and turn it into a real-world example. Small businesses are the heart of the American economy. However, many small business owners end up discouraged as they start out. Just like the penny, small businesses should see growth compounded year after year. That growth could be around 20%, 30%, 40% until it reaches a certain point. Then, that maturity pattern falls back to a 6% to 9% growth pattern.
If you are that business owner on day five, you probably still feel like giving up. Perhaps you’re on day seven or day 12; you see some growth, but you still feel like you are not reaping the rewards you see others gaining.
It’s not uncommon for me to talk to business owners and hear things like, “I’m 45 years old, and I have very little money in my 401k. I have friends that took the corporate route with $400,000 sitting in their 401K. My $30,000 pales in comparison. What am I going to do for retirement?”
I argue that while it may be true their investment account may seem lacking, they own a successful business that will benefit them later on in retirement. They see that their income is good now, and they make more money than their friends on the corporate route. But they question where the value is in the long run.
Here’s the thing. Looking at the value of your business in the first 10 years is like looking at the value of that penny doubled in the first 10 days. When you look at the penny after 20 days it is a bit more valuable, and the same goes for your business at 20 years. Stop looking at the now. Look to the future.
I do know that a business is not going to double every day for 30 years. However, the compounding interest principle still holds true. In our “magical” penny example, value at day 20 may be just over $5,000, but by day 31, it’s more than a $10 million! That’s just 11 days…which is around less than half the time you already invested in doubling your penny. The same is true of our investment accounts, our retirement accounts, our business value, our real estate assets, etc. I could keep going, but you get the point. Growth will take place!
The older we get and the more time passes, the more exponentially our assets growth takes off. However, the problem is as we near those retirement years, we become more conservative. Fear creeps in and overwhelms our decision making. We panic and convince ourselves we are going to lose everything we’ve ever worked for if we don’t start pulling back on our investments. IF the people with the magic penny allowed fear to overtake them once they made it to $5000, then they would never make it to $10 million—and they just had 11 more days!!
I understand that we are dealing with real businesses and real assets, and I’m using this crazy analogy about a “magical” penny, but you need to understand the concept is still the same. We need to build on the value of our business or let our investment accounts grow. Before you reach retirement age, your increasing assets do not need to become decreasing assets. It’s imperative that they are positioned for rapid growth.
Don’t hit 50 and go all conservative. Let it grow. There is no “magical” age for getting conservative, just like there is no “magical” penny. The markets could be treacherous but let your assets grow! It will be okay. Once you hit retirement age, then turn your appreciating assets into income-producing assets. That’s the point when you want to become more conservative. Until then, let compound interest work its magic so you can earn it, not pay it!