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The Most Powerful Financial Lesson I've Ever Learned

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May 29, 2009 – Comments (20)

While there's some doubt as to whether or not Albert Einstein actually quipped, "The most powerful force in the universe is compound interest", I can't think of a more profound financial lesson.  In fact, were I able to teach our young daughter one and only one financial concept, it would most assuredly be this one.

Anyone who's spent any time around The Motley Fool has certainly run into this lesson many times over -- and for good reason.  It's fundamental to understanding how nearly everything involving money works -- from credit cards, to home and car loans, to bank accounts, investments, you name it.

In fact, in what now seems a prior lifetime when I was in my 20's and managing movie theaters for a living, some of the teenagers who worked for me probably thought me a bit odd as I would rather often try to teach them just how powerful compound interest can be, both working for them and against them.

Frankly, if only more of us truly understood this fundamental concept, a good bit of the financial turmoil we are facing could have been avoided.

Sure, we've all read the articles declaring just how much $100 per month invested at, say, 10% per year in the stock market can grow to after 20 years (by my math, the $24K invested will grow to about $72,400).  Some of you might argue that the 10% figure is too high, and fair enough, but the concept remains the same.  Exponential functions are powerful things.

While I think most people understand this aspect of compounding, I think all too few seem to understand the flipside -- that the exponential nature of compounding is no less powerful when it works in the opposite direction.

Here is, perhaps, in a single sentence, the most powerful financial lesson I have ever learned:

Avoiding paying interest is the same thing as earning it.

Okay, for those of us who've hung around The Motley Fool for a while, this is 'old hat', but it sometimes amazes me how powerful the implications of this simple lesson are.

I'll never forget when I was just getting started in my adult life (back when I was preaching the power of compound interest to kids pouring artificial butter flavoring on overpriced popcorn).  Sure, I had a credit card in my wallet, and sure, there were lots of things I would have liked to have had that were but a swipe of the plastic away...  but every time I considered prying the card from my wallet I'd remember the above lesson.  "Why, on earth, do I want to pay 20+% interest?  If avoiding paying interest is the same thing as earning it, how much is that shiny whatchamacallit going to cost me in the long run?"

Now, I did, from time to time, use my credit card back in those days.  Most often it was because I was driving an older car that needed repaired from time to time.  Unfortunately I wasn't, yet, financially savvy enough to build-up an emergency fund, so when my car did need repaired I had to whip out the plastic -- after all, I did need transportation to and from work and school.  When that bill did arrive in the mail, though, I paid it with a vengenance.  No, I couldn't always pay off the entire balance, but I would always pay off as much as I could.

In fact, I guess one could say that I dislike debt.  Frankly, it makes me feel uncomfortable.  I dislike knowing that, in the long run, I'll have less money, and fewer shiny whatchamacallits to enjoy because of it.  This doesn't mean that I have no debts today -- I have a few -- so maybe 'dislike' isn't quite the word.  But I like to think I have a profound respect for it.  Like many powerful tools, it can be used and misused and one has to be ever careful one is engaging in the former rather than the latter.

I keep hearing news stories about the state of our economy that seem to talk about the failings of our debt-driven economy -- that much of our economic growth over the last few/several years (if not longer) has been fueled by consumer debt, and this reduction in consumer debt is at least partially responsible for our contracting economy.  While for those who've lost their jobs it may come as little comfort, in the long run, I can't help but think this is a good thing.  After all, what works for one of us works for all of us.  If we, as individuals, will find greater financial prosperity by utilizing less debt, then we, as a country and economy, should also.

Of course there's one debt I still owe which was probably the singlularly greatest financial decision I've ever made in my lifetime -- and that's the outstanding balance on my student loan from grad school.  The difference that education has made in not only my earning power, but in the quality of my life, far outweighs the cost.  That is, indeed, an example of debt used to fund a true investment -- an investment with a greater return than the cost of the debt used to fund it.  Okay, I realize I'm starting to ramble here, which wasn't my intention...  but I bring up this point because I all too often hear politicians say "We have to invest in this or that" while I know they'll be utilizing debt to do so -- and, of course, all too often that so-called investment is anything but.  Now, I'm not suggesting that the particular government program in question isn't worthwhile, worth doing, or perhaps even worth utilizing debt to do so.

But I think, all too often, our government makes the same mistake many of us do -- failing to realize that in the long run we'll have more of the things we want our goverment to provide us by using less debt.

All right, I suppose I've rambled seemingly endlessly for long enough -- especially over a topic that is likely well known by just about everyone who's spent any time here at The Motley Fool...

But when the time comes to begin to teach our daughter about money and finance (she's just shy of five years old now), I'll start with the lesson that, whether Einstein said it or not, compound interest may just well be the most powerful force in the universe -- and avoiding paying interest is, financailly, pretty much the same thing as earning it.

Regards,

Russell (a.k.a. TMFEldrehad)

 

20 Comments – Post Your Own

#1) On May 29, 2009 at 12:22 PM, tdoodler (24.69) wrote:

Nice post - nice reminder.   FYI:  Last weekend I opened a pass book savings account for my 8 yr old daughter.  (She had a prior account at a different bank - but now, I was able to open a good old fashioned passbook savings account).  So instead of getting that seemingly stale statement in the mail, she now has a pass book that she can update whenever she wants - and see the compounding.

Unfortunately with rates so low, the interest is very very small.  So to help intice her to save and understand the benefits of saving, I promised her that in December, i will give her triple her interest.  When rates eventually rise, she will hopefully really understand compound interest.

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#2) On May 29, 2009 at 12:55 PM, portefeuille (99.60) wrote:

... , I can't think of a more profound financial lesson.  In fact, were I able to teach our young daughter one and only one financial concept, it would most assuredly be this one.

here is another one from a different field:

"Matter is made of atoms" (see section 1-2 of this lecture by Feynman (pdf) (the section starts on page 13/20).

similar but shorter (read the pdf mentioned above, it is better!): 1 (bottom of p. 682 ("Why is this important?")), 2 (#23 on p.90).

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#3) On May 29, 2009 at 1:02 PM, portefeuille (99.60) wrote:

(see section 1-2 of this lecture by Feynman (pdf) (the section starts on page 13/20).

(see section 1-2 of this lecture by Feynman (pdf) (the section starts on page 13/20)).

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#4) On May 29, 2009 at 1:05 PM, h2ound08 (< 20) wrote:

excellent post, thanks.  this was a lesson that i did in fact learn from TMF, and one which i have applied as often and as strictly as i could.  i carried a balance on my credit card while in college, which was pretty close to the limit.  as soon as i started reading up on TMF and realized the harm i was doing i paid it all off in a matter of weeks, horrified that i was actually putting myself deeper and deeper in debt.  now the only debt that i have is my student loans (and i agree with your views on those above).  thanks again.

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#5) On May 29, 2009 at 1:31 PM, JakilaTheHun (99.94) wrote:

I totally agree. 

I'm not very happy with the direction of political dialogue in this country.  We hear political ideologues who want to paint the entire world with a broad bushstroke ("government = bad" or "social services = good") rather than analyzing things from a rational perspective. 

I believe that every single government action should be justified from a Taxpayer ROI perspective.  Every single debate for every bill should revolve around this concept.  If making a certain infrastructure investment provides a positive return for taxpayers, then the policy might be good (there are still other considerations, naturally).  However, if the proposed investment provides a negative return for taxpayers, then the policy most certainly must be bad.  I think if we viewed public policy through this lens, things might be a lot better.

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#6) On May 29, 2009 at 1:39 PM, jstegma (29.22) wrote:

I agree that compound interest is an important financial lesson to learn.

However, as I blogged in March, I think there is a pretty powerful counteracting force of some kind acting against it over long periods of time. 

Irrational Optimism about Long-Term Investment Returns

Compound interest calculations appear to hold true over 20 years, but they don't work over 2000 years.  Somewhere in there they go terribly wrong.  See the above for more detail.

 

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#7) On May 29, 2009 at 1:49 PM, russiangambit (29.27) wrote:

I thought it was gravity. All those years of education wasted.lol.

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#8) On May 29, 2009 at 1:58 PM, dbjella (< 20) wrote:

 TMFEldrehad -

Great Post!  My question to all of you from the following: 

The difference that education has made in not only my earning power, but in the quality of my life, far outweighs the cost.  That is, indeed, an example of debt used to fund a true investment -- an investment with a greater return than the cost of the debt used to fund it. 

Is there a cost of education that becomes too high to meet a quality of life?  I ask this question because several of my friends, back in my college days, choose to go to private liberal art schools at a cost that was 3,4 and even 5 times the state school I attended.  As they entered the workforce all of them found work in something other than their major.  They all started at lower wages.  In my opinion, it took them at least 5 years to reach my salary level and 10 years to pay off their student loan.  Their wages have never exceeded mine.  Also, I don't think their college experience was radically different than mine.

Maybe my experience is the exception, but I see children and parents get sucked into the fancy names for their institutions of higher learning.  In my opinion, it is not the school that will set them apart from their peers.  Outside of the sciences, it is the childs ability to communicate, manipulate and adapt to people that will set them apart.

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#9) On May 29, 2009 at 2:01 PM, portefeuille (99.60) wrote:

no, planets are held together by gravity and the earth is attracted to the sun by gravity, but the atoms are held in their place by the attraction/repulsion described by Feynman. maybe not that great an idea, but stuff would be really messed up without it.

i wonder how alstry prepares for that ... 

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#10) On May 29, 2009 at 2:09 PM, Alex1963 (28.46) wrote:

Every time I instruct my broker to sell a 20-30% gainer and he repeatedly advises "let it run" and I repeatedly remind him "Not in this market thank you". He then likes to say "Well no one ever went broke taking profits/making money" Which is either stupid or profound. But I like him so I'll say profound. When it's more reliably bullish I'll likely join his buy & hold/let the winners run mode LOL.

Good post rec #14

Alex 

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#11) On May 29, 2009 at 2:09 PM, russiangambit (29.27) wrote:

> no, planets are held together by gravity and the earth is attracted to the sun by gravity, but the atoms are held in their place by the attraction/repulsion described by Feynman. maybe not that great an idea, but stuff would be really messed up without it.

Well, yes. Without it we wouldn't have the electricity. May be it is electricity that is the most powerful force. Can you imagine life without it? We still would've been in the middle ages, no computers.

As for compounding interest, it lost the much of its luster since the central banks started interfering with it.

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#12) On May 29, 2009 at 2:15 PM, portefeuille (99.60) wrote:

Without it we wouldn't have the electricity.

Why would that be so?

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#13) On May 29, 2009 at 2:16 PM, portefeuille (99.60) wrote:

read the pdf (everyone). you u.s. americans like the feynman style (just teasing) ...

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#14) On May 29, 2009 at 2:20 PM, Big50Shooter (< 20) wrote:

Portefeuille,

I think the quote from Enrico Fermi, which appears as #19 on your above link to p.90 applies here:

"Before I came here I was confused about this subject. Having listened to your lecture I am still confused. But on a higher level."

LoL.....

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#15) On May 29, 2009 at 2:47 PM, portefeuille (99.60) wrote:

#14 thanks for the laugh. I think I start my weekend (friday 8:47 p.m. here) ...

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#16) On May 29, 2009 at 2:51 PM, TourPhare (38.26) wrote:

Too bad nowadays the young ones ie teenagers just don't buy that idea of living below your means. They spend money without thinking about saving for a rainy day, they reason that they still have decades of working life to earn back what they spent. I know this might make me sound like Ebenezer Scrooge but yes they might still be working for 30 to 40 years to come but you'd never know when you might get retrenched, which I'm sure many older people are starting to realise now (no offense). If only these teens realise that by saving and letting it multiply through...yes, you guessed it... the most powerful force aka componding, they will have a pretty sizeable nest to fall back on.

To be honest I'm a teen too, 18 to be exact. And like you Russell I try to preach them about the importance of saving and being financially literate such as being able to interpret financial statements and understanding the economics and the power of investing, I usually ended up getting remarks such as 'Dude what's wrong with you talking about all this stuff?' or getting dirty looks and being treated (sometimes) like an outcast.

Unlike them, I had little interest in the latest fashion and football blah blah blah and that sometimes make me feel like an outsider. But I do know that I'm having a headstart and 10 years down the road when they began to realise the importance of saving and investing, I might be a mile ahead.

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#17) On May 29, 2009 at 4:07 PM, peachberrytea (78.06) wrote:

Jakila: "I believe that every single government action should be justified from a Taxpayer ROI perspective.  Every single debate for every bill should revolve around this concept."

Good concept, but difficult in practice. How do you quantify the return that taxpayers get from something like peacekeeping? Or the benefits of the bailout package? No one knows for sure where would be with/without the package. Only time will tell. Further, politicians will just use the ROI as a means to justify their actions so it won't even be a check on a politicians' policies (i.e. a politician fudges the "return" or benefits of a policy so that justifies implementing the policy).

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#18) On May 29, 2009 at 7:51 PM, Chaine42 (< 20) wrote:

My wife and I are out of debt for the second time in our lives.  What a change in perspective without having to pay all of that interest every month.  We now have discretionary funds to invest on a monthly basis, rather than paying the usurers.

 

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#19) On May 29, 2009 at 8:38 PM, JakilaTheHun (99.94) wrote:

peachberrytea,

Most undoubtedly politicians will try to fudge the numbers.  But so do corporate execs and salesmen.  We've come to expect that in life. 

My bigger issue is that the dialogue isn't even focused on this concept to begin with.  At least if it were centered on that, it would force politicians to address it and if they were full of BS, they could more easily be called out on it. 

My biggest problem with the bailout was precisely that it probably won't generate a positive ROI for taxpayers.  There were several ways policymakers could have combated the crisis while still getting a positive return for taxpayers --- but instead, we were told "fixing the system" was more important, so the proposal we got favored special interests (who always care about their return) and screwed over everyone else.

Certainly, there are always things that "can't be quantified", but at least when you put a price tag on them, you know how much they cost.  Our politicians don't like putting price tags on things.  They like ordering the steak without looking at the prices on the menu.

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#20) On June 03, 2009 at 8:12 PM, foolsMeThrice (99.63) wrote:

you are right on point.  We would have no balanced budget problems since 20% of our GDP goes to servicing the debt.  Politicians are in a powerless position.  Your constituents want XYZ, and if you don't give it to them well your not reelected.  Nobody, absolutely nobody likes to be told to exhibit self control but that is exactly what all of this boils down too.  The American attitude (I am American) is that of entitlement across all class strata.  People would rather work three jobs with a spouse that's working perhaps two than to come to terms with the fact that the life they are trying to live is beyond their means. And then people complain that things are so hard for them.  People want to keep drinking that koolaid. Forget drinking it they guzzle it.  They baste in it.

I'm the kind of person that does not find it fulfilling to spend 1000 a month on a new beamer or mercedes.  Unless ofcourse buying that mercedes is the equivalent of buying a pinto.  I don't find it fulfilling to spend 2800 a month on rent in manhattan even though I could afford it.  Instead I rough it out in Newark in a dumpy place paying 800.  I pay month to month, and can leave at anytime and go where the work is if needed.  And in doing so I have been able to save my stake so I can get ahead.

1) Debt is a form of a bond.

2) The word bond in the financial sense is derived from bondage.

3) Bondage is slavery.

On the miracles of compound interest, I'll be running my automated trading system soon.  The flip side of compound interest is compound returns (if your system works) or compound losses (if it don't).  Sure it sounds risky if you don't understand it or performed the regression with years of historical data and months of intraday tick data.  It's quite the opposite.  The system is dynamic and adaptive automatically.  At a certain point though I will need to hone my skills as a long term investor since the weight of the trades at a certain point will be too large to profit from. 

People in their quest for the pursuit of happiness, which is in other words the pursuit of money as our founding fathers intended it, don't realize that credit which gives you access to money now is quite the opposite.  By choice you've just entered an agreement to enslave yourself.

Credit is debt.  See items 1) 2) 3) above.

The key issue to our problems now is that our money system is based entirely on credit.  Without perpetual debt, all money vanishes.  So a net contraction of 3.5 percent global debt means the global GDP is guaranteed to contract.  This debt contraction is guaranteed to continue.  Thus I don't see GDP growth until the debt spiral stops collapsing.

 

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