Now, this wouldn’t be the first time I’ve cited Albert Einstein as having described compound interest as ‘mankind’s greatest discovery.’
Perhaps of little wonder too, that the renowned theoretical physicist who was so inspired as a child by a compass – he thought there must be some force in what was presumed empty space that acted on it – would later find so much satisfaction in formulas that help explain some of the most powerful invisible forces in the universe.
But the confusion that surrounds these things is often ubiquitous. And in my most recent Letter from Linlithgow (March 2017), I explain how badly people often underestimate the effect of compound interest on money and investments at different rates of return (that’s net of charges / taxes, etc.).
For example, and this is roughly speaking, I’ll quote the FT 100 total return over 25 years at about 8% per annum growth (without charges).
By comparison, master investor Neil Woodford was a bit over 12% per annum after charges, etc.
And so our brains might then automatically assume the former head of investments at Invesco Perpetual (he left to set up Woodford Investment Management in April 2014) would produce about 50% more of a return over the same period.
And they would be wrong.
You see, if the actual FT 100 total return was up 591% then folks could assume that Neil’s 12% per annum return would be 50% higher at 886.5%.
Now that’s still a very good reason to buy Woodford rather than the “cheap” passive investment option.
But they’d be missing the magic.
You see, compound interest doesn’t work like that.
The actual difference between the two options – the FT 100 and Neil Woodford – is actually 591% and 1756%.
So, instead of being 50% higher it’s actually 3x higher – like ‘Money for Nothing and More Cheques Tax Free!
In my most recent Letter from Linlithgow (March 2017), I explain how badly people often underestimate the effect of compound interest on money and investments at different rates of return (that’s net of charges / taxes, etc.).
And taking that a step further, I shudder to think of how wide the difference is between Neil Woodford’s returns and those received from Cash ISAs over the last eight years of the lowest interest rate environment in centuries.
No wonder the rich get richer, and the vast majority get to retirement with next to zilch.
Too many people forget that the risk in avoiding any risk at all, are the returns you miss out on by doing so.
And no one ever got wealthy by investing in a deposit account.
Think about it. Talk to someone about it. Then do something about it.
Because after all, it’s your money.