Albert Einstein famously said, "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it."
But what is this great wonder and how does it work?
Here's Compounding 101!
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1/ First, some quick definitions.
Simple interest is interest that is paid only on the initial principal balance.
Compound interest is interest that is paid on the initial principal balance plus the accumulated interest from prior periods.
You earn interest on your interest!
2/ Let's use a simple story to illustrate the incredible power of compound interest.
Imagine you work for a tech company that was just acquired by Google. You cash out your stock options and receive a windfall of $1 million.
Your colleague Paul is in the same situation.
3/ You and Paul both decide depositing it in a bank is the safe move.
Simple Bank offers a high-yield savings account with 10% simple annual interest.
Compound Bank offers a high-yield savings account with 8% compound annual interest.
*Disclaimer: No, these rates are not real.
4/ Paul sees the 10% rate from Simple Bank and opens an account, depositing his $1 million.
You, on the other hand, have read the Einstein quote on compound interest, and decide to open an account at Compound Bank.
You're in this for the long-run.
So what happens next?
5/ Paul's 10% simple interest will earn him $100K every year (10% on $1m principal).
Your 8% compound interest will earn you $80K the 1st year (8% on $1m principal), $86K the 2nd year (8% on $1.08m), etc.
You earn more interest every year. Paul earns the same amount.
6/ After 1 year, Paul has $1.1 million and you have just $1.08 million. He gloats about his financial prowess.
"Just wait," you tell him confidently.
By year 7, you have leapfrogged Paul.
By year 20, he has $3 million to your $4.7.
By year 30, he has $4 million to your $10!
7/ "You should have listened to my guy Albert," you tell him over the phone from the library in your mansion.
The key here is that with compound interest, you receive the rate of return on both the principal and the accumulated interest.
It creates a snowball effect, of sorts.
8/ The same concept applies to stock markets, as the returns of this year compound upon the returns from last year.
Historically, putting money in a market index fund and allowing it to compound (reinvesting dividends) was the simplest, best way to build long-term wealth.
9/ I'm all for keeping things simple, except when it comes to interest.
Trust Einstein. Whether with savings, investments, or knowledge, let it compound!
10/ Following up on this thread, and inspired by @MorganHousel and his recent book (which is fantastic, by the way!), I'll be be sharing more stories of ordinary people who have built extraordinary wealth through simply harnessing the power of compounding. amzn.to/2ZNwgw6
10/ So that was Compounding 101! I hope you found it useful.
And for more educational threads on money, finance, and economics, check out my meta-thread below!
I think the whole “alcohol is poison” thing is too black and white.
Social connection is one of the most important factors for your physical health.
If having a beer with your friends promotes that connection, good for you.
If it doesn’t, also good for you.
The point: Do you.
I’ve personally reduced my alcohol consumption about 90-95%, but if I’m with a new or old friend and they want to share a drink of something special, I’m in.
Further, as a society, I think that we should worry less about the couple of beers we drink per month and more about the fact that we stare at phone screens all day, argue on social media with strangers, consume too much sugar, and are far more sedentary than our ancestors.
I'm thrilled to announce that my first book—The 5 Types of Wealth—is officially available for preorder everywhere books are sold!
I believe this book is going to change millions of lives. Its ideas have already changed mine...
So, what is The 5 Types of Wealth all about?
It's about rejecting the default and living life by design.
It's about realizing that your wealthy life may involve money, but in the end, it will be defined by everything else.
In this book, I offer a new way for you to think about your life centered around five types of wealth:
• Time Wealth
• Social Wealth
• Mental Wealth
• Physical Wealth
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A new way to measure what matters, make better decisions, and design your life around the pillars that truly create lasting joy and fulfillment.
Importantly, this book will not give you the answers. It will give you the right questions, so that you can uncover and act on them.
While the lens through which you view them will be individual, the stories, questions, ideas, and tools contained in this book are universal.
No matter who you are, or where you are on your journey, this book is for you.
If you’ve enjoyed any of my work, you’re going to find immense value in this book. I guarantee it.
My humble ask: Preorders are extremely important for the success of a book—retailers use the data to determine buys, placement, and more—so I'd be truly grateful for your support as I continue on my mission to create millions of positive ripples in the world.
If you reply and share this tweet, I'll personally message you my thanks and a few ideas I think you'll enjoy in the book. No automations, just me, because real impact is personal and human.
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I used to make fun of my Dad for buying People Magazine at Hudson News to read on planes.
The silent productivity killer you've never heard of...
Attention Residue (and 4 strategies to fight back):
The concept of "attention residue" was identified by Dr. Sophie Leroy in 2009.
The idea is simple:
There is a cognitive cost to shifting your attention from one task to another. When our attention is shifted, a "residue" remains and impairs our performance on the new task.
It's relatively easy to find examples of this effect in your own life:
You get on a call but are still thinking about the prior call.
An email pops up during meeting and derails your focus.
You check your phone during a lecture and can't refocus afterwards.