The magic of compound interest

The magic of compound interest

Already the Holidays are going through the wringer, no need for me to cause another disappointment, you think. I apologize, but I must …

Since parents are forced to admit years of lies at some point by telling their children that Santa Claus does not exist, I have to bring you back to reality, friends: the “magic of compound interest” is a myth.

I know we’ve been telling you this fantastic tale for ages. I suspect financial advisers are perpetuating this folklore to coat their beige stories with a supernatural aura.

You know what I’m talking about. To encourage us to save, the advisers show us a graph that climbs almost exponentially and culminates, after 30-40 years, on an unimaginable fortune.

“You see that, my boy, it’s thanks to the magic of compound interest. It must be taken advantage of early! Ho! ho! ho! There is nothing enchanting here, sorry.

What is compound interest?

I am not denying the existence of compound interest, it is a very real phenomenon in finance. In a nutshell, it’s when you calculate interest over interest.

You take a sum (the capital), you deposit it in a financial product that generates interest, this return is added after a certain period to the capital, on which the interest accumulates again.

Consider $ 100 which grows at 4% per year. After 12 months, we will end up with $ 100 plus $ 4 in interest. The return will then be “capitalized”, as we say, so that the interest for the next cycle will be calculated on $ 104.

In the second year, this bonus capital produces $ 4.16 in interest income. We therefore start the third year with $ 108.16 which will generate $ 4.32 for a new total of $ 112.48, and so on (see the vertiginous increase in interest).

Magical ? It could be called a miracle if the rest of the economy stopped running in exactly the same way.

Compound inflation

This week, there was a significant increase in food prices. We anticipate an increase of 3% to 5% over the next year. This will represent an additional expense of $ 695 for a family of four, it is said.

This surge is not compared to what we paid five years ago, it is compared to what food is costing us at the moment, the price of which has already increased for 12 months.

Inflation is also “compound”, and we are not marveling for all that. Its impact means that the basket of groceries costs us today 240% more than in 2000. Without salaries which also increase in a “compound” way, we would no longer have the means to eat. .

Even more striking is the development of house prices in certain markets. Not a month goes by without receiving a new batch of statistics showing strong increases, again with reference to the prices of the previous year, which were already inflated compared to the year before.

In 2000, the duplex I live in (the top) was purchased for $ 200,000. A 10% increase in the value of the building would have enabled its owner at the time to sell it for a profit of $ 20,000 the following year.

The duplex has since been converted into a condominium. The ground floor alone is now “worth” two and a half times the price paid for the whole building 20 years ago. A 10% increase in the value of this single unit now represents a capital gain of $ 50,000.

It’s a good thing that the returns on our investments are compounded, because we would all be homeless.

An illusion

So what’s the deal? On the whole, the evolution of the cost of things follows a similar trajectory to that of this small nest egg which promises to turn into treasure under the “magic” effect of compound interest.

If a modest pot does not allow us to buy a house today, the jackpot it will become in 30-40 years will not open up access to the real estate market, which will also have increased.

Compound interest is greatly overvalued. When a young person starts saving, its effect is insignificant. It will remain so without the contribution of a significant savings rate and a high rate of return.

No magic. Just effort and risk. It is less wonderful.

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