The Power of Compound Interest

Albert Einstein called compound interest "the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."

If an idea is powerful enough to inspire that level of awe from Einstein, I'm secure enough to admit my consistent and ceaseless wonder at it.

Recently, we looked at some portfolios' historical returns. On their faces, the differences in annualized return didn't seem dramatic. One portfolio had outperformed another with modestly less equities and more bonds by 0.24% annualized (7.17% to 6.93%) over 25 years. An aggressive portfolio of all equities had outperformed a conservative portfolio of mostly bonds by 0.85% (7.54% to 6.69%) over 25 years. Seemingly, hardly enough of a difference to make it worth taking extra risk, right?

Well, if you had invested $1 million in each portfolio, after 25 years that extra 0.24% would have translated into $301,516 more ($5,461,509 to $5,159,993). The extra 0.85% would have meant an extra $1,085,088 ($5,959,468 to $4,874,380). Wow.

These numbers dwarf my expectations using (too) simple math. My first reaction was to estimate using straightforward multiplication:

$1 million x 0.24% = $2400 x 25 years = $60,000

$1 million x 0.85% = $8500 x 25 years = $212,500

Only off by a factor of 5. 

We come across examples like this all of the time. And I'm always impressed. At least I'm in good company.