Lesson One: Understanding Compound Interest

Welcome to Lesson One of Investing Bootcamp.

(for an audio version of this lesson (yes, I’m going to read to you!) click the play button above)

I can’t tell you how happy I am to spend the next 30 days together, learning the basics of investing. Becoming a successful investor is way easier than you might think, and is an absolute must on your path to becoming fabulously, independently and unapologetically wealthy!

Before we get right into this first lesson, I would like to say this: Don’t worry if at first these concepts and terms sound scary or boring. I am here to help you learn, understand—and (hopefully) do it with a bit of humour.

Cool?

We are going to kick off the Bootcamp with a primer on compound interest. If you already know the super fun (almost magic) math behind compounding, feel free to consider this a review or skip this one and wait for your Day #2 email tomorrow.

Let’s get started.

Why are we kicking off with compound interest?

In 2015, the Wall Street Journal published a working paper on financial literacy—the results of which were not pretty. Two of the key questions were designed to test the
participants understanding of compound interest and inflation.

(today we cover compounding, tomorrow we tackle inflation).

The results?

Only half of the respondents over the age of 50 were able to answer the questions correctly.*

And another super-scary statistic?

38% of men answered the questions correctly, compared to only 23% of women.

But you know what? That’s OK. Over the next nine lessons we are going to learn everything that was in that financial literacy test and much, much more.

The Question:

Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?

A. More than $102
B. Exactly $102
C. Less than $102

We can find the answer by calculating compound interest.

Answering the question:

You have $100, and you put it in a savings account that pays 2% per year. At the end of the first year, you will have $102. (100 x 2% or 100 x 1.02 = 102). That is after one year. The question asks how much you will haver after five years.

Working this out from day one:

Year 1: 100.00 x 1.02 = $102.00
Year 2: 102.00 x 1.02 = $104.04
Year 3: 104.04 x 1.02 = $106.12
Year 4: 106.12 x 1.02 = $108.24
Year 5: 108.24 x 1.02 = $110.40

After five years, you would have $110.40 which is more than $102.

The answer is A.
Simple arithmetic would tell us, we should have $110 ($100 x .02 x 5 = $110). But compounding—as demonstrated above—gives us $110.40.

If you think that $0.40 is not much to get excited about, let me give you another example:

You have a 34-year-old daughter, Debbie, and you want to help her get started with investing. You have some money from the sale of your house and transfer $50,000 into a TFSA for her (we will cover what a TFSA is in Core Lesson Seven)

At 64, she decides to consider early retirement. (You are in excellent health, by the way. Debbie tried to reach you to tell you the good news, but you, at age 89 and a with a brand new hip, were on a biking trip in the Alps with no signal…)

Debbie logs into her brokerage account. She clicks the “performance” button and receives a PDF report showing her the account has made an average of 8.0% per year, since inception 30 years ago.

Based on the above example, does Debbie have:

A. $170,000
B. $120,000
C: More than $500,000

[this space purposely left blank for thinking!]

OK, bonus points to those of you that guessed (C), Debbie has $503,132.84.

Simple arithmetic would tell us that Debbie earned $120,000 in interest (50,000 x .08 x 30 = $120,000) Add to that number the original $50,000 you contributed for her and her simple arithmetic total would be $170,000.

But because of compound interest, it is not $170,000; it is $503,132.84.

I told you compounding was important.

Think of it as “your interest earns interest, and that interest earns interest, and that interest earns interest, and…” OK, you get the point.

That wraps up this lesson.

Be well and invest wisely,

Nanci

P.S. Click here if you are interested in reading more about the 2015 working paper on financial literacy, published by Pension Research Council, The Wharton School of the University of Pennsylvania.
P.S. #2 If you would like to run your own scenarios for investing (like Debbie, years and amount invested, including any annual deposits) visit this link.

The Fine Print:

Investing Bootcamp is provided as an educational resource and should not be construed as individualized investment advice, nor as a recommendation to buy or sell specific securities. The investments and scenarios discussed in the course are examples only and may not be appropriate for your individual circumstances.

The investing strategies presented in Investing Bootcamp will result in losses during any period of decline in the broad stock and bond markets. All investments carry the risk of loss. It is the responsibility of individuals to do their own due diligence before investing in any index fund or ETF mentioned in this course.

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