Although we often hear about the “wonders” of compound interest, many people don’t know what it actually means and they miss out on its benefits.

Two quotes are attributed to Albert Einstein regarding compound interest. Einstein apparently referred to compound interest as “the greatest mathematical discovery of all time,” and on another occasion he claimed that it was the “eighth wonder of the world.” Although we don’t know if these quotes are accurate, there is definitely something magical about compound interest.

What is it?
Compound interest is the ability of an asset to generate earnings, which are then reinvested in order to generate their own income. In other words, the term “compounding” refers to generating earnings from previous earnings. The magic of compound interest transforms your hard-earned money into a very efficient tool for building long-term capital. For compounding to really work, however, it is necessary to reinvest all earnings over time. When an investor gives more time to his investments, he is more likely to optimize the income potential of the original sum.

Example
If an investor had $5,000 in an account that paid 5% annually in simple interest for five years, he would earn $250 a year. This would generate a total of $1,250 in interest. In this case, the interest rate and the yield are the same — 5% per year.
However, the same $5,000 investment paying 5% in compound interest could earn more. In this situation, if the money is reinvested and compounded annually for five years, it would produce a total of $1,381.41 in interest. This is because when the investor earns interest on his interest, the yield — an average of 5.52% per year — is higher than the actual interest rate at which he initially invested. This difference of 0.52% a year may seem insignificant, but we should also consider that the investor did not need to work to receive this money. Moreover, this half a percent could make a significant difference over a longer period, such as 20 or 30 years.
The Earlier the Better
When an investor starts investing at a younger age, he will benefit far more from compounding. To understand this further, let’s take the case of two investors named Tzivia and Moshe Aryeh, who are both the same age. When Tzivia was 25, she invested $15,000 at an interest rate of 5.5%, which was compounded annually. By the time Tzivia reached 50, she had $57,200 in her bank account.

Moshe Aryeh, on the other hand, did not start investing until he reached the age of 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Moshe Aryeh reached 50, he had just $33,487 in his bank account.

What happened? Both Tzivia and Moshe Aryeh are 50 years old, and both invested the same amount of money ($15,000) at the same rate of interest (5.5%). However, Tzivia had $23,713 ($57,200 – $33,487) more in her savings account than Moshe Aryeh, even though he invested the same amount of money! By giving her investment more time to grow, Tzivia earned a total of $42,200 in interest while Moshe Aryeh earned only $18,487.

Annual Contributions
The above example clearly demonstrates the positive benefits of compound interest. Taking it a step further, imagine that Tzivia, who invested $15,000 at the age of 25, also adds an extra $2,000 a year to her account, where everything is invested at a rate of 5.5%. If she were to continue this disciplined investment approach until retirement (at the age of 65) she would end up with over $413,000. And if Tzivia were to add some risk to her investment profile in the hope of getting an even higher return, her nest egg at retirement could grow even more substantially.
The Cost of Waiting
As mentioned earlier, the two essential aspects for compounding to work are reinvesting the earnings and time. Each year that goes by without any investment will therefore affect your retirement. If you have 30-40 years until retirement, every year that you forego saving or investing money today may subtract between 1-5 years from your retirement.

Just Start
You don’t have to be wealthy to start investing. If you start saving early and make disciplined contributions, compounding may mean that you, too, can retire with a very large nest egg.
 

Aaron Katsman is President of Global Investments at Profile Investment Services.  He is a licensed financial professional both in the U.S. and Israel, and helps people who open investment accounts in the U.S. Securities which are offered through Portfolio Resources Group, Inc. a registered broker dealer, Member FINRA, SIPC, MSRB, SIFMA. For more information email aaron@profile-financial.com

Techcrunch had good coverage of Wikinvest’s launch of embeddable, annotate-able, wiki-able charts.  Wikinvest, which like it sounds, is a wiki focused on building out user-generated company and stock information.  Now, the site has developed charts that can be annotated and embedded into websites and blogs.

If you check out Apple’s chart (sorry wordpress.com doesn’t allow posting of javascript) and click on ‘B’, you’ll see that on June 10th, Apple reported a new iPhone with GPS and 3G capabilities, better battery life and improved audio quality.

Or, on Amgen’s chart, you can click on ‘L’ and see someone’s explanation for a continued slide in the stock price (which he/she attributed to a potential safety risk for Aranesp)

Google Finance has charts that attempt to pair up news events with movements in the stock price.  While it’s a really interesting cause-effect, Google Finance unfortunately doesn’t capture the news or information that is affecting stock price movement.  I attribute this to 2 reasons: 1) Sometimes it’s just impossible to explain price movement (sorry, financial commentators) 2) Google’s news set is in some cases unexplicable weird and picks up stories that seemingly have little impact.

Anyway, these charts powered by wikinvest are interesting for financial bloggers and may ultimately do a good job of providing numerous opinions as to what’s affecting individualk stocks at any given moment.  It would be very interesting for someone to look into the accuracy of wikinvest’s annotated charts and provide some metrics at some point (if this is possible to track).  If anything, these charts improve on Google’s charts (which I happen to like) by overlaying wiki-like UGC on top of stock charts.