The Compound Interest Formula And How Albert Einstein Discovered It
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Did You Know Albert Einstein Invested In The Stock Market And He Devised Compound Interest For Your Savings:
Albert Einstein was born in Germany on 14th March 1879. For those of you that didn’t pay attention in your physics lessons at school, he was a theoretical physicist and widely recognized as one of the most influential scientists and inventors the world has ever seen. He was the man that discovered the ‘Theory of Relativity’ and the renowned equation E = mc2.
You may not also know that in 1921 he was awarded The Nobel Prize for Physics, an amazing achievement especially when one of his headmasters told him ‘nothing would ever come of him!’ Albert went on to invest his prize money into the stock market, but unfortunately when the market crashed in 1929 during the Great Depression it resulted in him losing the majority of his investments.
He wasn’t known for his investing abilities, but he did identify the most amazing mathematical revelation known as ‘compound interest’. Albert referred to it as the eight wonder of the world.
Now for all you investors this is valuable information definitely worth a read:
What Is Compound Interest?
Before we delve into the advantages and structure of compound interest we need to clarify what it actually is.
It is essentially the interest that has been calculated on your initial investment and your interest you have accumulated from income from previous years. So basically it is ‘interest on interest’, therefore your investment will mature at a faster rate compared to simple interest.
Compound Interest Explained:
Now to comprehend ‘compound interest’ the easiest way is to begin with how you achieve the simple interest.
1. Deposit money into your account
2. Your bank pays you interest on your deposit
For example: Tom has invested £100 and his bank pays him 5% annual interest.
So after just a year, he has made £5 on his original deposit of £100.
What happens next year?
This is when ‘compounding interest’ occurs.
Basically you start to earn interest on your original deposit AND you would earn interest on the interest you have just earned.
With me so far?
So the interest you earn in the second year will be greater than the year prior as your original balance was £100 is now £105. So basically you didn’t pay any money into your account but your earnings have increased due to the interest..
1st Year: Invest £100 earn 5% annual interest (£5) increase balance to £105
2nd Year: Investment £105 earns 5% annual interest (£5.25) increase balance to £110.25
3rd Year, 4th Year and so on..
Patience Is A Virtue:
We need to be patient when it comes to investing, the notion of compounding doesn’t occur overnight it is a gradual process that can take years. By planting those initial seeds (small amounts) you will see your tree grow (savings increase). Hence patience is a virtue…
If you change some of the key factors I.E. the interest rate or the number of years you hold the investment for your savings will increase. So basically the longer you leave your savings and don’t be tempted to touch them, then overtime the ‘compounding interest’ will increase.
Disadvantages Of Compounding:
If you borrow money the same concept does not work in your favour, but works in the favour of the lender.
Let’s go back to Tom again and ‘compound interest’…
Tom borrows money from the bank, now he is aware he pays interest on the money he borrows but the next month April was a hard month for him and he didn’t pay the interest. Now, Tom not only owes money on the interest on his original amount he borrowed but he also owes the interest that has accrued from April. See how easy it is for Tom to start falling behind.
The moral of the story is try and pay off debts as quickly as you are financially able to do so. But if you are finding things hard then try to keep borrowing rates low, as the higher the interest rate on any loan you have will dictate how fast that debt can grow, then the longer it will take to clear. If possible combine the debts as this should reduce the interest rates whilst you pay off the loan and in the long run save you pounds.
Compound Interest Equation:
Your Formula To Calculate Compound Interest:
B = D (1 + [ r / n ]) ^ ny
B: Your closing balance
D: Your original deposit
r: Yearly interest rate (wrote in decimals)
n: No. of compounding periods (I.e 12 monthly & 52 weekly)
y: No. of years your money compounds
Example: Tom has £1,000 wages 5% compounded on a monthly basis.
Let’s work out for Tom what he will achieve in 15 years.
- B = D (1 + [ r / n ]) ^ ny
- B = 1000 (1 + [.05 / 12]) ^ (12 * 15)
- B = 1000 (1.0041666…) ^ (180)
- B = 1000 (2.113703)
- B = 2113.70
Therefore, Tom will have a closing balance of £2113.70 achieved in 15 years of saving. Remember £1,000 is his original deposit and £1,113.70 is the compound interest he has achieved. Pretty impressive, huh?
Checkout our spreadsheet for live compound interest calculator:
Albert Einstein’s Most Powerful Equation:
E = mc2
We can also apply Albert’s equation to trading.
Emotion = Money x Contracts
The more contracts you have, can potentially mean you make more money / lose more money but it can also equal more emotion.
Final Note On ‘Compound Interest’:
‘’Compound interest is the eight wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” — Albert Einstein
Which basically means that by grasping compound interest you have the determination and the motivation to achieve your goals, by making your money work more effectively for you.
Positive Quote To End On:
“Once we accept our limits, we go beyond them.” — Albert Einstein
