Compounding Interest
A piece of information that I thought might be useful to describe again. Because the subject of what I'm about to talk about, “What is Compounding Interest”, that is exactly what LBI is going to grow big with.
Compound interest is an investment effect where you earn money on your previously earned return. It is a way in which you can achieve huge returns with a relatively small investment.
Albert Einstein once said of compound interest:
“Compound interest is the 8th wonder of the world. He who understands it, earns it. He who doesn't, pays it.'.
Warren Buffett
An example of someone who has become immensely wealthy is Warren Buffett. By investing consistently from the age of 11, he has now built up a wealth of no less than $101 billion.
Of course, we all want to be the ones who understand compound interest and earn it. But Not everyone really understands this. And that's exactly why writing this blog could be a good read once again. It could help you understand the power of compound interest.
But what is compound interest? How exactly does it work? What are the advantages and disadvantages? Are there even disadvantages? And how do you apply it yourself?
What is compound interest?
Compound means compound and interest means interest. Compound interest actually means compound interest. However, this doesn't really explain what compound interest exactly means. A better translation would be: interest on interest.
Simply explained, compound interest means that you will receive interest again on your previously obtained interest. Suppose you receive 1% interest from your bank and you have an account on which you have $1,000.
So you will receive $10 in interest in your first year. In your second year you will receive $10.10 in interest. That's because you got 1% on $1,000 in your first year, but 1% on $1,010 in your second year. That way you always receive interest on your previously earned interest and you actually earn 'free money' on your 'free money'.
With the interest you receive from your bank, however, this effect is nil, because even 1% today is an interest that you can hardly get at your bank. Today you can think of an interest rate of, for example, 0.01% or even a negative interest rate at your bank, and that is a line through the account of many people who understand the principle of Compound Interest well.
When you start working with higher interest rates, for example in the form of returns you achieve on your crypto, the effect of compound interest becomes really interesting.
For example, imagine that you invest $1,000 in crypto. For example, in your first year you will achieve a 15% return, spread over the entire year. So at the end of the year you have €1,150 and you have actually 'earned' €150. In the second year you now achieve a return of 15%. That means that at the end of the second year you will receive € 1,322.50. So you 'earned' €172.50 in that year, while in principle you have achieved the same return.
In the long run, this effect becomes even more interesting. For example, suppose you achieve a return of 10% on an amount of $1,000 for 50 consecutive years. Then at the end of these 50 years you will have an amount of no less than $144,369.92!. We will explain exactly how you calculate this later in this blog.
That is huge and it is precisely the reason that many people mainly look at investing in the long term. While you may think $100 isn't much in your first year of starting with $1,000, this same return would pay you nearly $10,000 in the long run.
What's so great is that in the long run you actually earn interest on interest on interest on interest on interest, etc. That basically means that you earn free money on free money on free money, etc.
However, it can also be the case that in a year you achieve a much less return, or even a negative return. This can of course have a significant effect on your compounding interest. While there are of course beautiful sides to this effect, it's not just sunshine and rainbow.
This effect shows once again why it is important to stay consistent in your investment process. Crypto doesn't always have to be a get rich quick scheme, but it certainly can be a get rich slow scheme.
What are the advantages and disadvantages of compound interest?
Compound interest is therefore a very nice effect, which can ensure that in the long run you really get a lot of return from a relatively small investment. Later we will discuss Joris' calculation example, in which this can be seen very clearly.
The phenomenon actually has one very clear advantage, but also one very clear disadvantage.
Advantage: the biggest advantage of compound interest is the fact that it is a great way to achieve a very nice return in the long term, without having to invest a lot. For example, it is not at all unrealistic to think that you will become a millionaire through compound interest by putting in 'only' €100 per month, especially if you start early.
Disadvantage: with this we immediately address the sore point of compound interest; provided you start early. Compound interest takes time. You cannot expect to become a millionaire within two months by means of compound interest. You have to give the effect time, and then it will certainly give you good results in the long term.
When you know and understand this biggest advantage and biggest disadvantage, you can make a decision for yourself whether the long-term returns are worth the wait for you. There are, of course, other ways in which you may achieve comparable returns in a short period of time. However, this often involves much more risk.
How do you calculate compound interest?
You can actually calculate compound interest in two different ways: firstly, you can calculate it by heart / with a calculator, but there are also various tools online that allow you to calculate it automatically. Let's take a look at both now.
Calculating compound interest is not that difficult. You can use this formula:
E = I x R^J
E = final amount
I = deposit amount
R = interest per year
J = number of years
To calculate your final amount, you therefore need your investment amount and your final interest rate. You can calculate your final interest rate by multiplying your interest per year to the power of the number of years.
When you multiply these two components together, you get your final final amount.
Calculation Tools
And if you're not a math genius, don't understand formulas at all, or you're just lazy. No problem, because then you can simply calculate the compound interest with various tools on the internet.
It doesn't really matter which tool you use, but a good example is the 'Compound Interest Calculator' from The Calculator Site.
The tool works as follows;
- Indicate which currency you want to use.
- Now indicate your initial balance, or your investment amount;
- Now enter an interest rate.
This can be, for example, the percentage that you estimate to achieve per year or per month. You can then choose whether this return should be added to the calculation per day, per week, per month or per year; - You can then enter the time period over which you want to calculate the compound interest.
This can be years and/or months; - You can also indicate several other things.
For example, you can indicate whether you want to deposit an additional amount per month, and how much this amount is; - Then click on the 'Calculate' button and the tool will automatically calculate your final amount.
See what your investment will yield you
So it is very easy to calculate your compound interest. It can be very helpful to do this before getting into an investment. This is because it can give you a very good idea of what exactly the investment will yield you.
A calculation example with compound interest
Let us now look at a calculation example involving compound interest. We will also show you the amount at different times in between, so that you can really experience the power of compound interest.
We look at the example of Dave. Dave is 18 years old, and has worked hard at the fruit grower and he has saved up an amount of $1,000. He decides to invest this in crypto. He still works at the fruit grower and can therefore put another $100 per month in crypto. He plans to do this until he turns 68. During this 50-year period, Joris achieves an average annual return of 10% per year.
By entering this data in the previously mentioned tool, we find out that Joris has an amount of $1,877,809.00 in crypto on his 68th birthday, while he has only invested $61,000 in total.
The power of compound interest becomes even clearer when you also see the intermediate steps. That is why we will now draw up a table showing the intermediate steps of every 5 years.
| YEARS | Amount deposited | Total Amount |
|---|---|---|
| 0 | $1,000 | $1,000 |
| 5 | $7,000 | $9,389.02 |
| 10 | $13,000 | $23,191.54 |
| 15 | $19,000 | $45,900.95 |
| 20 | $25,000 | $83,264.96 |
| 25 | $31,000 | $144,740.29 |
| 30 | $37,000 | $245,886.19 |
| 35 | $43,000 | $412,302.46 |
| 40 | $49,000 | $686.108.62 |
| 45 | $55,000 | $1,136,604.35 |
| 50 | $61,000 | $1,887,809.0 |
In the table you can see very clearly that the longer you do this, the higher your result is. This is of course because you earn more and more interest on your increasingly previously earned interest.
A nice lesson you can learn from this is that you sometimes have to be patient, in order to achieve great results in the end.
But does it always work this way?
However, what is extremely important to know is that this is an extremely simplified calculation example. In the real world, and certainly in the world of crypto, it never really works that way.
It almost never happens that you have so many years in a row achieves a constant return. For example, you may achieve 25% one year, -37% the next, and 51% the following year. It can be very inconsistent and of course this has a huge impact on the outcome of your compound interest.
Where can you get compound interest?
Depending on how you invest, compound interest is very easy. With many investments in crypto, the money automatically stays in the investment and it will therefore also start to compound, but not with all. LBI & SPI are both perfect examples of Compound Interest.
HODL
Are you someone who does buy and hold? Then you will in principle not have to do anything to be able to enjoy compound interest. However, there is one thing that you should not do, if you want to enjoy compound interest. You do not have to extract your return every year as 'profit', because then you will never start compounding.
Liquidity Providing
There are also crypto investments where you have to manually compound. This is, for example, when you do liquidity providing. Liquidity providing is a way to generate passive income with crypto, by providing liquidity to decentralized exchanges.
In exchange for providing this liquidity, you will receive rewards. In principle, these rewards simply appear in your wallet as tokens when you claim them. In this way you do not benefit from compound interest. You can of course start compounding, because you do this by always putting the tokens you receive back in. And that is the power of Cubdefi Kingdoms. Autocompounding farms!
So it is quite easy to ensure that you can enjoy compound interest, but it is smart to check whether you are doing it right when you open a new position.**
Conclusion
So, the eighth wonder of the world, compound interest, is a security in the investment world. It is the effect that can most easily be explained as interest on interest. With compound interest, you therefore earn interest on your previously earned interest.
It takes a lot of time, but when you are patient...
Then you can save up a lot of money in the long run, without having invested a lot for it.
However, it has to go very well with your investments.
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compounding interest is what makes me hold, there I did it.. just typed it out normally for a change.
In crypto as well as stocks (well, etf's actually) letting it all compound is the way
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This is one of the biggest reasons why HODLers win and consistently outperform traders. The numbers you point out are pretty amazing. Now just think what they could look like with 20% a year. Due to the compounding effect, waaaay more than double the numbers you used. That's what LBI is looking to pay every year, right? And so far this year we're over 40% and we're only 3/4 through. Pretty amazing. Get some for your kids. I did.
The great thing is that due to such great returns, you don't even have to keep adding every month. It will take longer to get to the bigger numbers but it's basically a 6x in 10 years, 37x in 20 yrs, 222x in 30 yrs, 1337x in 40 yrs. Albert Einstein was right....
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The hard part with compounding is getting the ball rolling, once that happens it's pretty easy. Also you should leave the math for Mondays because Math Mondays sounds way cooler than Math Sundays :P
It just takes time so I think a lot of people are unhappy with the normal method because they want quick returns. The cause is probably social media and all those news articles about people striking it rich. But I still think compound interest is the a slow but steady way with little risk.
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Compound interest is the thing that most people miss in their investment journey. Even if anyone is compounding less amount then it adds up to a really big number in the long run. The thing we have to look for is the discipline through which we start compounding and follow the same thing until the end.
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It is true that compound interest is wonderful and also that many people do not have the patience to reap its fruits. They are more than take the money and run!
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This is indeed the eight wonder of the World. The slow and steady growth is the best way to grow. One just need to exercise patience and discipline while one keep compounding. It the long run it would certainly be better.
A very nice summary of a very important financial concept.
She who understands it, earns it, she who doesn't, pays it. Interest on your interest.
Perfect, I like it.
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Read how this all have started with Toruk
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There's another disadvantage of compound interest: if it applies to debt instead of savings/investments. Albert Einstein's quote you included in the post captured that, actually:
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