Recently I asked the following question in the office: assume you are really strong, you tear a phonebook in half and stack the two halves on top of each other. You tear the stack and put the new parts on top of each other again. Once more, you tear and stack. You get the idea. Now the question was: how many times should you repeat this process in order to be able to jump off the stack onto the moon? My colleague’s answers ranged from 5,000 to 1,000,000 times. Before reading on, how many times do you think you would need to tear and stack the phonebook?
A Force Not to Be Underestimated
A colorful group of professionals works at Lendahand. The "Wisdom of the Crowd" theory dictates that when you average the guesses of people from various backgrounds, the average guess closely resembles the true value. Have a look at this BBC video (from the 1 minute 45 second mark).
Unfortunately, the Lendahand team is not big enough to come up with a good estimate, on the contrary, we were off by a long shot.
To reach the moon, the process only needs to be repeated 33 times! It wasn't that we overestimated the distance the moon is the earth, rather our massive overestimation was caused by our massive underestimation of the effect of compound interest.
Compound interest is the addition of interest to the principal sum of a loan, deposit, or investment. Put simply, it's making interest on your interest.
Einstein is said to have made the statement: “The most powerful force in the universe is compound interest.”
Compound Interest and Tennis
Let’s illustrate this with another example. Say you are a tennis player and you are able to train every day for a year and increase your skills incrementally by 0.2% daily. After just one year you have become twice as good at tennis as you were when you started.
Now on the other hand, if you don’t train, your skills decrease by 0.2% daily. Therefore in this scenario after one year you have become half the tennis player you were. The small difference between -0.2% and 0.2% per day translates into a difference of a factor of 4 in a year’s time! This is approximately the difference between being a top 100 player worldwide or placing 8th at your local club competition.
The Effects of Saving and Investing
Everyone has probably noticed that interest rates are historically low. The interest rate on your savings account is lower than inflation. In real values, you are actually losing money by saving. After all, in a year's time, you can buy fewer products with your savings, including interest, than today. Also, capital taxes should be taken into account, lowering the spendable amount further. All in all, your savings are shrinking instead of growing. And it’s happening fast! Look at the influence of a small daily decrease on the tennis player.
To flip from small losses to small profits in real values on a periodical basis, you have to make some choices and be willing to take some risks. For example, you could increase your mortgage repayments (bringing along the risk of ‘investing in stones’). Another option is investing, whether in stocks, bonds, or startups. Or you could go another route altogether and visit thisiswhyimbroke.com and spend all your money today!
What is true wisdom? No one knows, but in this case, doing nothing (keep your savings where they are) is also an option, whether you like it or not.
How to Accomplish a Moon Landing
Compound interest is a force to be reckoned with, so is improvement on top of improvement. At Lendahand we offer both by combining an attractive interest rate on your (risk containing) investment with growth opportunities for entrepreneurs in emerging economies.
The moon is 400,000 kilometers away and a phonebook is 5 centimeters thick. May the power be with us!