It is a tale of two savers. One, fresh from university, begins diligently putting aside €200 a month at the age of 25. Her friend, preferring to spend his salad days on foreign holidays and overpriced coffee, waits until 35 to begin saving, albeit at double the rate: €400 a month. By the time both reach the traditional retirement age of 65, the early starter will have amassed a considerably larger fortune, despite having contributed far less from her own pocket. Her secret weapon was not a spectacular stock-pick or a fortuitous inheritance, but a force as quiet as it is relentless.
That force is compound interest, the process by which the earnings on an investment themselves begin to generate earnings. It is, simply put, interest on interest. Far from being a dry accounting concept, it is the fundamental engine of capital accumulation, the mathematical bedrock upon which fortunes, pension funds and entire economies are built. To grasp its power is to understand the most potent, yet often neglected, principle of finance.
The tyranny of time
Its logic is simple; its effects, profound. An initial sum invested at a steady rate of return grows not in a straight line, but in a curve that sweeps ever more steeply upwards. A sum of £10,000 earning 7% a year—roughly the historical average for stockmarkets—becomes nearly £20,000 after a decade. So far, so good. Left for 30 years, however, it does not merely triple; it burgeons to over £76,000. The growth in the 30th year alone is more than four times the growth in the first. This is the happy tyranny of the exponential function, where time is a more powerful ally than the size of the initial investment.
The procrastinator’s penalty
Why, then, does this seemingly obvious path to wealth remain untrodden by so many? The answer lies more in psychology than in finance. Human intuition is notoriously poor at grasping exponential growth, preferring the comforting linearity of simple addition. The lure of immediate consumption proves far more compelling than the abstract promise of a distant, larger reward. This “present bias”, as behavioural economists call it, explains everything from inadequate retirement saving to the lamentable tendency of governments to favour short-term spending over long-term investment.
A double-edged sword
For compounding is a ruthlessly impartial force. Just as it can diligently build a nest egg, it can also inexorably enlarge a debt. A modest loan, left to fester at a high interest rate, can swell into an intractable burden. It is the pernicious magic that powers payday lenders and fuels sovereign-debt crises. A state that indulges in profligate borrowing finds itself on the wrong side of the equation, with an ever-larger share of its revenues consumed not by public services, but by servicing a burgeoning pile of liabilities. Inflation, a government’s stealthy tool for managing its own debt, is the mortal enemy of the compounder, silently eating away at the real value of his returns.
Albert Einstein is often credited with having called compound interest the most powerful force in the universe. The attribution is almost certainly apocryphal, but the sentiment is not. Its unswerving logic cleaves the financial world in two: those who earn it, and those who pay it. For individuals and chancellors alike, the most crucial decision is which group to be in.