Einstein has called the interest rate phenomenon the eighth wonder of the world. Or so, just in the investment world, people like hockey. There is, of course, no certainty as to whether Einstein actually said this words.
However, it does not detract from the importance of the interest rate effect, as the phenomenon is the key to why long-term investment is so profitable.
The interest rate phenomenon is so important that if the placement were a TV series, there would be a cliffhanger between production seasons before the interest rate effect opened. To do so, such incredible plot twists would be promised that viewers would surely return to the screen in the next production season.
Well, what is this all about now? Let’s move on to the investment literature to look for answers:
The formula for the interest rate phenomenon is as follows:
Oh, hasn’t it opened yet? Let’s hear the definition right after:
“The interest-to-interest effect refers to a phenomenon in which the return on assets increases interest in addition to the original principal.”
At this point, viewers who have returned to the home couch will start browsing Instagram.
After all, they were promised breathtaking plot revelations. What is this s**t ?!
No worries, fortunately this text is dedicated to the very revelation of the phenomenon of exploding interest on interest that only the eighth wonder of the world deserves.
Let’s start from the beginning.
When you invest money in the stock market, stock market curves are expected to rise over the long term, giving your investment a certain return expectation. The return is the investor’s salary for the risk taken.
Let’s take an example where you once invest 100 euros on the stock exchange. The expected return on your investment is 6% per annum (average stock market growth after inflation).
After a year, your capital has increased to 100 x 1.06 = 106 euros, as your return expectation has been realized and your investment has increased interest rates.
But we were talking about the interest rate phenomenon. So let’s wait another year.
That’s when your return (the 6e you earned) has also increased by 6%.
In practice, after two years, your initial capital (100e) has increased interest rate again by 6% (6e), but the return for the first year (6e) has also increased interest rate by 6% (0.36e)!
So in two years your capital will be 106 x 1.06 = 112.36e.
In three years, your capital will be 112.36 x 1.06 = 119.10e.
And so on.
You haven’t done anything else at this point once you’ve invested $ 100, and now the money is working for you.
Okay, I still don’t urge you to take patches of your day job. Financial independence has not yet been achieved.
But now that the phenomenon itself has opened up, one can move on to those chocolate peaks. In order to take full advantage of the interest rate phenomenon, two important conditions must be met:
In the first few years, the interest-to-interest phenomenon produces only a few dozen, but when the investment horizon is further away – say, even 30 years – the return on interest begins to surpass the amount of capital you invest. While your invested capital will grow linearly with your monthly savings, your real capital will grow exponentially.
In the picture, you can see the golden portion of the bar is the money your investments have made! If this is not radical, then what then.
However, as an investor, you must not fall into the trap of fund costs. The rule of thumb is that management costs should not exceed 0.5%. You can get the most out of this phenomenon by investing in completely expense-free funds.
The reason for the importance of cost-effectiveness is that they eat the interest rate effect of the phenomenon. While the “only one percent” fund costs recommended by the banking girl at a discount don’t seem high in an instant, they have time to accumulate over a decade as a large salary for the bank.
Image copied from the Stock Exchange Foundation’s page.
The picture shows how important annual return is to your capital growth. In all curves, the initial capital is the same – 1000 euros – but depending on the annual return, the value of the capital in 20 years will vary by several thousand.
For example, if you want to save € 50 a month on a monthly basis, you will have a stack of € 47,434.91 with an annual return of 6% in 30 years. But if your bank’s investment adviser suggests you a fund with expenses of 1% per annum, you will only have € 39,863.31 in your hand with the same annual return! In that case, you have paid a whopping 7,571.60 euros. So you should look for the most cost-effective option for long-term savings.
If you’re looking for investment inspiration, I recommend using the interest to interest calculator (*) to calculate your returns.
It’s always good to remember that there are, of course, risks associated with investing. However, the risk decreases as the investment horizon lengthens, so there is another good reason for long-term investment. The risk will be discussed in more detail in a future post.
Time for upper mothers! If you kept reading until now, you have done yourself a tremendous service today!
And if you think the interest rate phenomenon is a tough thing, you and Einstein have something in common.