Howard Lindzon posted this recently - a post by Akre Capital about the power of compound interest. The entire article is terrific but this riddle really brings home the point:
You are given the choice between two sums of money: one million dollars or a penny that will double every day for 30 days. Which should you choose?
Here are a couple hints. The penny that doubles daily would be worth $1.28 after the first week. After the second week, it would be worth $163.84.
You will probably reason that the penny would be worth more than the one million dollars. (Why, otherwise, all the theatrics?) By just how much, though, might surprise you.
It turns out that after doubling 30 times, the penny would be worth $10,737,418.24!
This is a terrific exercise because it highlights the not-so-obvious power of compound returns (in this case, the penny compounds at 100% for 30 periods).
I say not-so-obvious because you would have been better off taking the one million dollars until the 27th day. But in those final four days, the value of the penny increases from less than $700,000 to more than $10.7 million. Patience and a long-term perspective are required to give the power of compounding an opportunity to do its magic.
Most do not naturally grasp the concept of compound interest. It has been called the eighth wonder of the world (first by Albert Einstein, supposedly) for good reason. Most of us have to learn to appreciate it. And even once learned, we have to remind ourselves periodically of its wonder.
From this riddle, we learn the importance of holding on so that we allow our investments to compound uninterrupted for long enough that the compounding effects we saw in days 27 to 30 have an opportunity to play out in our portfolios.
There are a few key lessons:
- The benefits of compounding are often not visible until later. Patience counts. You are wrong for a long time, but then suddenly, you can become unequivocally right.
- The small continual changes will far outweigh the sudden big ones.
A great reminder.