Failing to understand Exponential Function and Compound Interest

When it comes to mathematical functions, the human brain can easily comprehend “Linear Function or Simple Interest”, but we are genetically unfit to comprehend “Exponential Function or Compound Interest” and its massive impact years down the road.

When it comes to interest rates, do not trust your intuition—you don’t have any.  Accept it and use a calculator instead.

Simple-vs-Compound-Interest

For example: Newsflash “Inflation is at 5%.”  Whoever hears that might think, “That’s not so bad.”  But it means that in 14 years, a dollar will be worth only half what it is today; a catastrophe for anyone who only have a savings accounts, earning a measly 1% interest (= money destruction) instead of putting that hard earned money in ETFs or the stock market, so as to earn significantly more than the 5% inflation rate over time.

Another powerful example: There is this guy, who for more than 10 years is permanently on the list of the richest people on the planet.  His name is Warren Buffet, currently worth roughly US$68 billion.  Interestingly, US$65 billion was added only after his 60th birthday.

Assuming he would have invested like the regular guy and started saving in his 30s, and then retired in his 60s, you would have never heard of him.  Why?  His secret is time and compounding.  He started at the age of 11 and is now 84 years old.  70 over years of compounding really do make a difference.

You say that you are not Warren Buffet and are way beyond 11 years old?   Ok, fair enough.  What do you think about this example?

By reducing your Starbucks fancy coffee consumption/cable TV/hand phone/unnecessary insurance premiums by just $200 a month, you can expect to generate about $37,000 in investments in 10 years, assuming 8 percent annual returns.  That portfolio could grow to nearly $700,000 in forty years.  Hard to believe?  Try it out yourself.

Think about that.  From the time you are in your 20s and 30s until your 60s, your monthly wages might double or triple.  But money saved in your 20s and 30s could very realistically grow tenfold by the time you reach your 60s.

Saving a little bit of money when you are young is a more efficient way to build wealth than saving a lot when you’re older.

Time allows the market to do the heavy-lifting wealth-building for you.  Go and let time work for you.  Start saving as early as you can, but latest when you get your first paycheck.

“The Ninth Wonder of the World is Compound Interest.  Those who understand it, earn it, those who don’t, pay it.” — Albert Einstein (or some other clever guy who knows what’s going on)

“The greatest shortcoming of the human race is our inability to understand the exponential function.” — Prof Albert Bartlett

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