Compound Interest

Reading my weekly Stansberry investment newsletter I came across an article that I thought I would share.  This article is about compound interest and its importance.  Most people don’t realize how important compound interest can be; over time, money grows and as it grows and grows, eventually the growth becomes quite explosive.  Eventually, the money works for itself and grows exponentially.  Below, you’ll see a chart that gives an example of how compounding works.  But to give you another idea, lets talk about sheep:

Pretend that you are a shepard from the days of the bible.  You live in a tent with your wife and son and daughter and you have a flock of 8 sheep, 4 male and 4 female.  In the spring, your 4 female goats give birth and after the first year you now have 12 sheep.  The following year, your 6 female sheep give birth and you now have 18 sheep.  In the third year, the 9 female sheep have a baby sheep each and now you have 27 sheep.  4th year you have 13 more sheep and in year 5 20 baby sheep are born.  After 5 years, your 8 sheep have turned into 60.  Interest compounds a little slower than this but over time, as the money grows, you are compounding a larger and larger amount so that the amount of interest you receive each month becomes a substantial amount.

Imagine, some 20 or 30 years later, you have 1,000 sheep and in the spring, you have 500 new baby sheep.  Compound interest works like this.  Eventually, your “nest egg” is big enough so that the interest generated is more than your regular salary.  I am just totaling my dividends, interest and options premiums for December and my million dollar portfolio generated over $10,000 this month (combined interest, dividends and options premiums).  In the 3 months previous, my account has paid me  $6,456, $9,435 & $3,479.  I can remember back when my account had thirty or forty thousand dollars and my monthly dividends and interest might only be ten or twenty bucks.  One sheep born… years later, 500 sheep born.

From Stansberry:

In order to emphasize the power of compounding, I am including this extraordinary study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306. In this study we assume that investor (B) opens an IRA at age 19. For seven consecutive periods he puts $2,000 in his IRA at an average growth rate of 10% (7% interest plus growth). After seven years this fellow makes NO MORE contributions – he’s finished.

A second investor (A) makes no contributions until age 26 (this is the age when investor B was finished with his contributions). Then A continues faithfully to contribute $2,000 every year until he’s 65 (at the same theoretical 10% rate).

Now study the incredible results. B, who made his contributions earlier and who made only seven contributions, ends up with MORE money than A, who made 40 contributions but at a LATER TIME. The difference in the two is that B had seven more early years of compounding than A. Those seven early years were worth more than all of A’s 33 additional contributions.

This is a study that I suggest you show to your kids. It’s a study I’ve lived by, and I can tell you, “It works.”

So you can see that the investor who stared earlier ended nearly the same even though he invested much less money.  Over time, compounding can have a dramatic effect on your investments.  Previously we talked about the Rule of 72.  If you can get a high rate of return on your investments and let that interest compound over time you can save a million dollars.

Eventually, the interest earned on your investments is more than your regular monthly contributions.  When that happens, it is a great feeling!

Save, invest and grow your wealth until you are a millionaire.

Good luck!

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