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The Mental Model of Compound Interest

This article on Compound Interest continues my quest to list out the Top 100 Mental Models Needed to Succeed in Business, inspired by Charlie Munger.

Munger calls compound interest “one of the most important models there is on Earth.”

It arises when interest is added to the principal.

If you don’t know how to use compound interest on a calculator,  there are a couple of excellent online compound interest tables/calculators that do all the work for you here:

For example, If you start with $1,000 as your principal and earn 10% per year then you would have $1,100 after the first year. That’ easy enough: 10% on $1,000 is an extra $100. $100 interest per year seems alright.

However, things get much more interesting when you apply an interest rate return like 10% to both the principal (the original $100) and the interest each year (e.g. the initial $10 interest from year 1).

In year 2, for example, your value doesn’t just reach $1,200 ($1,000 plus $100 for 2 years in a row), it reaches $1,210 in total value ($1,100 * ($1,100*10%)).

The growth may still seem incremental, but if you take it out a much longer period of time it gets real interesting.

Let’s say you could invest that $1,000 starting amount and earn 10% every year for 20 years — that would leave you with 6,727.50 (over 6X your starting value).

And if you could somehow grow that same $1,000 starting principal at 20% per year, your ending value is not just double the value of the 10% interest example above, it’s 5x+ the amount ($38,337.60).

The stock market has tended to produce about 8% returns per year if you buy into the general indexes.

If you wanted to produce a million dollars over 30 years, you would simply have to pick a typical index fund and put $99,378 into it…and sit back and watch it compound.

Now that’s compound interest!