“Compounding, Man’s greatest invention”
Compounding
Many years ago Albert Einstein was asked what he thought mankind’s greatest invention was, he simply replied “compounding interest” This is one of the most brilliant human beings ever telling all of us how important this formula of compounding is for growing wealth. Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding.
Rule of 72
The “rule of 72” is a very easy way to figure out compounding of wealth based on a percentage return. Divide 72 by the interest rate you are earning to determine how many years it will take your money to double. For example, if you are earning 8% per year on your money it will take 9 years for your money to double in value. 72 divided by 8 equals 9. Eight percent is a decent average annual return and the number I set as a goal to beat every year. This should be easy for everyone to achieve as the average return from the stock market is said to be 10% if you invest in an index fund that tracks the market. For fun check what percentage you are earning on your money and calculate how many years it will take for it to double in value.
What does this mean to us?
The importance of compounding to us as individual investors is that we must set aside investment money for the long term and not withdraw the money earned from investing. It is necessary to compound the earnings on top of more earnings in order to maximize “mankind’s greatest invention” How much should you put away for investing? The general rule should be at least 10% of all earnings, after taxes, go into some sort of investment account. I would recommend an IRA either Roth or traditional if you qualify as the compounded earnings are tax deferred.
2 comments:
The "Rule of 72" brings me back to my financial management class; I had totally forgot about it until reading your blog entry.
Anyway, I've been really enjoying the posts so far. It inspired me to finally start-up a prosper account. Keep it up!
Paul (soon to be neighbor come January).
Glad to hear, neighbor!
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