For value investors, taking advantage of compound interest is the only way to realise long-term investments and grow value-focused portfolios. But, what makes compounding your interest such a powerful approach and how does it differ from simple interest?
All the talk on the block is of compound interest-this and compound interest-that... but why is it the way to go? In this blog, I've researched the differences between simple and compound interest, and delved into an understanding of the long-term approach necessary to reap a value investor's deserved benefits.
For all following formulas: P = Principal, r = interest rate (%); n = number of times compounded per year; t = number of years.
The Differences Between Simple & Compound Interest
What is simple interest?
Put as simply as possible, simple interest is a fixed, non-growing return on your investment. You usually reap simple interest with bond coupons and similar investments.
Simple interest is the oldest form of calculating interest. It’s what the Romans and ancient Egyptians used… which is why I see it as a bit of an aged formula. The simple interest formula looks like this:
A = P (1 + r x n)
(P = Principal investment; r = interest rate (%); n = number of time periods)
Are you beginning to see why this is outdated? It’s far better left to the ancient Egyptians, because it’s not a true reflection of interest deserved. Let’s look at a quick example of how simple interest works:
Principal investment: £100
Annual interest rate: 10%
Investment period: 1 year
A = 100 (1 + 0.1 x 1)
Total amount: £110
Annual interest earned: £10
Seems correct, right? Well, what if you had to dissect how you're earning interest throughout the year. Because you’re earning this interest over a year, this means that after one month you’re technically deserved one twelfth of your annual interest (£0.83). After the first month, your deserved amount is then £100.83. The issue with simple interest is, your year’s interest isn’t calculated on your increasing capital, instead it’s calculated throughout the year only on your principal investment. The formula is innately flawed to calculate interest for growing long-term investments. While it didn’t create a big issue for the ancients, a few years down the line someone experienced shock and horror and demanded that we invent compound interest.
What is compound interest?
The world rejoiced when compound interest was born. In many ways, it was like a savior for investors across the globe. It meant we could finally earn the interest that we deserved.
Compound interest has two formulae, because there are two types of compound interest: annual and continuous. Annual interest is compounded year-on-year (used for things like inflation), while continuous compound interest could be compounded daily, weekly, or monthly (used for things like savings accounts). These two compound interest formulae look like this:
Annual compound interest:
A = P (1 + r)n
Continuous compound interest:
A = P (1 + r/n)nt
The purpose of this new equation is to fix the issue that I brought up around simple interest. When compound interest was born, we could finally earn interest on our interest. The interest you deserve by holding a long-term investment is only realised with compound interest, like a self-fulfilling prophecy.
What Are the Benefits of Compound Interest?
Why am I going on about this? Because, compound interest isn’t just a value investor’s cherry on top of the cake… it’s the whole cake!
“Reinvesting your earnings and growth in capital, transforms money into a tool for further earnings and growth in capital. The law of compounding transforms time into one of your greatest assets. It is not to be underestimated.” – Scott Nursten
Without taking advantage of compound interest and understanding its benefits, long-term investments are near meaningless to value investors. For instance, take this quick example of compound interest:
Principal investment: £100
Annual interest rate: 10%
Number of times compounded per year: 12
Number of years: 1
A = 100 (1 + 0.1/12)1x12
Total amount: £110.47
Annual interest earned: £10.47
Yep, I know. That doesn’t seem very much more impressive than the interest earned on our simple interest formula. Only £0.47 more? But, if you keep this investment for 10 years, the outcomes are like so:
Simple interest: £200.00
Compound interest: £270.70
Look, an additional £70.70 is nothing to be sneezed at. But I'm guessing that you're still not too impressed? Well, I always said that compound interest was meant for the long-game. Look what happens if you stick around for 50 years with this investment:
Simple interest: £600
Compound interest: £14,436
Boom shakalaka! Now that's what I call impressive. With that long-term view, the benefits of compound interest are clear. It may take a while for the ball to get rolling, but when it does, it’s as if David Beckham’s dribbling down centre and no one can stop him. If it's sounding a bit unrealistic to stay in the game for 50 years strong, well that's just what everyone's favourite value investor did. Take a look here at Warren Buffett's value slowly increasing for the first 50 years, and then spiking as his compound interest kicks in:
That’s why value investors with long-term investments need to start early if they want to reap the rewards of compound interest. It’s not a get-rich-quick scheme, but it sure as heck is a get rich scheme.
If you want to know more about value investing and building your portfolio, download STRIDE’s eBook A Practical Guide to Value Investing: Building Your Portfolio below.