One of the many interesting guest-posts I will be hosting here. Thanks to Chris Sinclair from AimCFO.com.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein. Try to picture Einstein as this reality began to hit him.
Most people never pause long enough to consider the significance of this statement. Those that do usually only look at it from one perspective and that being money.
Money is one of those things that we all need at least some of and often seem to be lacking, at least from our perspective. Yet we often treat money as if it rules over us. We cannot seem to control how we spend and often don’t even think about saving. Yet saving money to prepare for the future is really something we all should be doing, and, as Einstein observed, these savings compound.
For example, assume you put aside $2,000 at the beginning of each year and receive 10% interest on the balance at the end of each year. I know 10% may be dreaming, but I’m using it for easy of demonstration. At the beginning of year 1 you have $2,000 but at the end of that year you have $2,200 ($2,000 + $200 interest). In year 2 you add another $2,000 for a total of $4,200. However, at the end of year two you receive interest not just on the $4,000 in principle you have added ($400), you also receive interest on the first year interest of $20 ($200 x 10%). You will have $4,620 after 2 years. If you carry this out for 20 years you will have $126,005. Of that you have contributed $40,000 in principle ($2,000 x 20), earned interest on the principle contributions of $42,000, and earned interest on the interest of $44,005.
Notice that most of your balance at the end of 20 years is from interest on interest. The balance of $126,005 is composed of $40,000 you contributed, $42,000 was earned on the principle you contributed and $44,005 was earned on the interest you accumulated. That is a demonstration of the power of compounding when it comes to money.
Compounding however is about More than Money.
While we typically think about the power of compounding in terms of money, it really applies to other aspects of life. Here are a few:
NETWORKING – As we build our personal and business networks we find that both opportunities and results compound. Each new relationship opens the door to more relationships which in turn open the door to even more. This is a playing out of the concept of six degrees of separation, which says that on average we are approximately six steps away, by way of introduction, from any other person in the world. We have more opportunities to help others and more people to help us. On top of that, we have more resources within our reach. As long as we build those networks with the correct motives (that is not just what’s in it for us), we are using the power of compounding in a fruitful and honest manner.
BUSINESS GROWTH – Have you ever noticed how a business suddenly seems to take off? While much of that is attributable to the efforts of management and employees, there is one thing that is somewhat beyond their total control – customers. As customers use a product of service, they frequently spread the word to others. Those people in turn spread the word to more and so on. As you see, this spreading of the word by customers is really a demonstration of the power of compounding. Of course, it is important to remember that this works both ways. If a customer is unhappy with us, we can quickly find the negativity spreading in a compound manner. This is a key reason that we need to be in regular contact with customers to address potential problems before they have the opportunity to compound.
PERSONAL REPUTATION – Just like networking and business growth, the personal impression we make on people has the potential to multiply exponentially. If someone has poor integrity, the word will spread. If another has a reputation for honesty and going the extra mile, this too will spread. This is really the idea behind a company checking personal references as well as business references for potential employees.
It’s Like Magic.
Actually, this heading is not exactly correct. While the power of compounding may seem magical at times, it really is a very logical process. Unfortunately it is lost on many people and companies. That is sad as they miss many opportunities to help others and get the help they need.
Think about it, and I think you will agree with Einstein that compounding is the eighth wonder of the world. Are you considering this as you go about your daily life?