Let’s start with the basics and work our way up. First, I’m sure you’ve participated in interest somehow whether that is the interest you pay on a loan or interest you’ve earned on an investment like a bond. Interest is essentially the price to borrow money. A borrower pays a lender interest for the privilege of borrowing that money.
Simple interest is the interest paid on the original loan amount over and over again. So if you lent someone $1,000 at 5% annual interest, they would pay you back $50/year every single year. Whoever named it simple really nailed it.
Compound interest, on the other hand, builds on itself or “compounds”. Imagine the same example above but the lender didn’t pay any interest back for a few years. The interest would be added back to the principle of the loan as such:
Year 1: $1,000 loan X 5% interest = $50 interest payment (not paid)
Year 2: $1,050 loan X 5% interest = $52.50 interest payment (not paid)
Year 3: $1102.50 loan X 5% interest = $55.13 interest payment (not paid)
Year 4: and so on…
It doesn’t seem like much in the first few years, but the interest payment is growing! That interest payment can get really big in a few years. Let’s take a look at my favorite compound interest parable; the invention of chess.
The story goes that the inventor of chess showed it the emperor of India. The emperor fell in love with the game and told the man to name his price for such an invention. The man responded simply saying he wanted a grain of rice on the first square then 2 on the second, 4 on the third, and for them to continue doubling until the board was filled.
The emperor scoffed at the foolish man for asking such a small reward and told the manager of his grain stores to start counting out the rice. He hadn’t heard back from the man in a day and sent for him. When the man arrived, the emperor asked what was taking so long and was met with the reality that they didn’t have anywhere near enough rice to fulfill the request and the request would have covered the entire area of India with over a meter of rice.
For perspective, I actually ran the number and on square 13, the man would hit one pound of rice. On square 19, it would already be 75 pounds. By square 24, it would have surpassed a ton. By square 43, he would have surpassed global rice production in 2019. On the final square of the board, the man would have nearly 1600 times the annual modern-day production of rice. Finally, because I’m a space nerd, the rice would have nearly been the mass of Jupiter’s smallest moon.
This same type of compound interest can occur in your portfolio, albeit on a smaller scale. It starts off slowly with seemingly meaningless dollar growth but once you get to further squares on the chessboard, that growth becomes significant. This is the same reason it is so hard to climb out of debt and people with money tend to make more of it.
This same principle is also why you often here the trope of “getting started early”. There is plenty of truth to it. Remember, the man had only 1 pound of rice at square 13 and 75 pounds by square 19. Every incremental square seems trivial in the grand scheme but the longer you invest, the more compound interest works in your favor.