![\"\"](\"https:\/\/www.cashflownavigator.com\/blog\/wp-content\/uploads\/2012\/05\/Einstein-Blog.png\" "\\"Einstein")
<\/a>I\u2019ve always admired Albert Einstein.\u00a0 After all, he was a fairly intelligent fellow.\u00a0 In science, he changed our understanding of light and of gravity, helped prove the existence of molecules, and explained the nature of space and time.\u00a0 In politics, he was influential as a promoter of peace and freedom.\u00a0 All in all, a very strong resume\u2019. \u00a0But for our purposes, his most impressive contribution was in the field of finance.<\/p>\nEinstein was reportedly asked what he thought the most powerful force in the universe was, and he replied, \u201cCompound interest.\u201d\u00a0 Another Einstein quote on this topic: \u201cCompound interest is the eighth wonder of the world.\u00a0 He who understands it, earns it\u2026he who doesn\u2019t, pays it.\u201d (1) <\/p>\n
The Einstein connection with a compound interest \u201ctheory\u201d was his association with the \u201cRule of 72,\u201d a simple formula for calculating how long it takes to double your money.\u00a0 All you need to do is divide 72 by the annual rate of return.\u00a0 For example, if you invest $1,000 in an account that earns 12%, divide 12% into 72.\u00a0 The result is 6, which is the number of years it will take to double your money.\u00a0 So there it is, Compound Interest, not E=MC2, is the greatest mathematical discovery of our time.<\/p>\n
Well maybe not, but at a certain threshold of savings the impact of compound interest is considerable.\u00a0\u00a0 And if you also make regular supplemental deposits to that savings (or investment) account you can essentially compound the compound interest effect.<\/p>\n
Einstein was reportedly asked what he thought <\/strong><\/p>\n the most powerful force in the universe was, <\/strong><\/p>\n and he replied, \u201cCompound interest.\u201d<\/strong><\/p>\n Let\u2019s take a look at three scenarios to illustrate the point. The first is a simple savings account. If you put $1,200 into savings at a bank at, say, age 22 and let it sit there at 3% APR compounded annually it would grow to $4,406 after 45 years when you\u2019re ready to retire at age 67. In our e-booklet, Wealth is Good, Cash Flow is Better<\/strong>\u00a9, we would consider a basic savings account like this a \u201c2nd<\/sup> Best\u201d asset, which means it EITHER appreciates (grows in value) OR generates positive cash flow but not both.<\/p>\n But doesn\u2019t it do both?\u00a0 Well, it does generate cash flow in the form of interest earned but note that the basic investment amount, the principal, doesn\u2019t grow.\u00a0 That\u2019s why it\u2019s second best.<\/p>\n At least it is better than the \u201cWorst\u201d asset type, which depreciates (loses value) AND also generates negative cash flow.\u00a0 A car or a boat would be good examples of \u201cWorst\u201d assets.<\/p>\n The second scenario is an investment account such as a mutual fund comprised of stocks. Let\u2019s assume this account, on average, grows at a compound annual rate of 6%.\u00a0 The growth comes from stock price increases and also dividends. Because the \u201cprincipal\u201d (the stock price) grows AND it also generates cash flow (from dividends), we classify this as a \u201cBest\u201d asset type.\u00a0 From an initial amount of $1,200 this investment grows to $15,583, or more than three times the value of the bank savings account.\u00a0 That\u2019s a nice improvement, but it still wouldn\u2019t cover many retirement expenses.<\/p>\n If on the other hand you make regular $100-per-month supplemental contributions to that same investment account, at a 6% compounded rate it would grow to over $255,000.\u00a0 Now that\u2019s better\u2026actually it\u2019s an enhanced version of \u201cBest\u201d.\u00a0 As illustrated in the graph, making regular contributions to investment accounts — such as 401-Ks or IRAs \u2013 creates a whole new dynamic. And with the help of compounding, the impact is particularly dramatic in the latter years.<\/p>\n