09 May 2021

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Finance for Dentists: The Power of Compound Interest

Author: Luigi Compopiano

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The basic concept for each saver is the importance of compound interest and how time can help us to grow our returns exponentially. This concept is easy but at the same time complicated. Investors like Warren Buffett and Ray Dalio made a fortune thanks to compound interest.

For those who have never invested, managing your savings can be very difficult:

• When starting?

• What to invest in?

• What if I lose everything?

These are the most common questions that we had set ourselves when we started investing. There is something more: where we live shapes our decisions, even the most important ones. We do not talk about investments with friends, and daily we hear the stock market is precarious. So, why do I have to invest? That is the reason why lots of savers leave their money in the bank account, believing safer. People who invest are often deceived by their eagerness because they do not see short-term returns and then leave their money in the bank account again (or in high-risk assets). In this case, they lose the opportunity to have the best ally for the growth of savings. 

Compound interest could seem a ridiculous and too slow concept in the concise term, but it is not. A small amount of money, if invested every month, becomes a vital hoard, especially for youth (time is our friend). We need to understand why compound interest is important and how it can help us generate long-term wealth.

Compound interest encourages us to sacrifice short-term savings now to achieve substantial long-term returns. To understand it, we need to compare compound interest with simple interest. Simple interest is a percentage of a number: for example, on a loan of 10.000$ at 8%, simple interest is 800$ after a year. Compound interest is a formula with which we get interested on interest. A simple analogy to which compound interest is often compared is the snowball thrown down a mountain. In the beginning, it is just a tiny and harmless snowball, but when it gets down to the foot of the mountain, it becomes an avalanche. Using the same example, in the first year our interest is 800$, but next year it becomes 864$.

Look at the table to compare:

Comparing simple interest and compound interest in 30 years 

What will happen if we invest every month? If a 23 years-old person starts investing 100$/month at an 8% annual rate, at 65, he/she will lots of money: we will invest almost 50.000$ but, thanks to compound interest, we will have 394.300$ at the age of 65.

In conclusion, the sooner we take the money off the mattress (bank account) and start investing, the sooner we get to our financial results.