The terrible compound interest

Einstein once said: "The greatest energy in the universe is compound interest" and "The power of compound interest is far greater than the atomic bomb." These are just Internet rumors, and there is no record showing that Einstein said that although compound interest is important, it is not so great!

Compound interest is just to keep the profit and continue to be used as the principal investment in the next period. The rate of return on investment is the real key. The true meaning of rate of return is growth rate, and compound interest is the concept of compound growth rate. To make funds grow rapidly, the decisive factor is of course the growth rate.

First review the term growth rate. Growth rate measures the growth or decline of a group of numbers in a certain period, such as one-year population growth rate, monthly revenue growth rate or decline rate, weekly net worth growth rate, etc. The period can be one day, one month or one year at any time. Calculated as follows:

Growth rate = (end of period-beginning of period) / beginning of period

The end of the period minus the beginning of the period is the difference of the current period, a positive value represents growth, and a negative value represents recession. The difference divided by the beginning of the period is the growth rate or the decline rate. For example, a certain city had a population of 100,000 at the beginning of the year, and by the end of the year it had a population of 110,000, which was 10% more than the population at the beginning of the year, so the population growth rate for that year was 10%. In terms of investment and financial management, the calculation formula of return on investment is as follows:

Return on investment = (amount at the end of the period-amount invested at the beginning of the period) / amount invested at the beginning of the period

It can be seen that it is exactly the meaning of the growth rate, so the rate of return on investment can also be regarded as the rate of capital growth, which is the ratio of the amount invested at the end of the period more than the amount invested at the beginning of the period. If 100,000 yuan is invested at the beginning of the period, the amount at the end of the period is 120,000 yuan, so the capital is more than 20,000 yuan, and the return on investment is equal to 20%. It can also be seen that the amount invested at the end of the period has increased by 20% compared with the amount invested at the beginning of the period.

If the growth part of each period is retained, the growth that continues in the next period is called the compound growth rate. If the beginning quantity is PV, the ending quantity is FV, ​​and the growth rate is g, after n periods, the formula for calculating the ending quantity of compound growth is:

FV = PV*(1+g)n

Compound interest is actually the concept of compound growth rate, so as long as the growth rate g in the above formula is replaced by the rate of return r, it becomes the final net value (FV) formula of compound interest:

FV = PV*(1+r)n

For example, with an investment of 100,000 yuan at the beginning of the period, the rate of return on investment is 20% per year, and the net value after 40 years is 146,977,157 yuan [=100000*(1+20%)^40], which is equivalent to 1,470 times the investment amount. This kind of capital explosion makes many people think that compound interest is really great. But is this caused by the power of compound interest? If the annual rate of return is only 1%, the net value after 40 years of compound interest is only 148,886 yuan. This shows one thing. The real protagonist of capital growth is the rate of return on investment, while compound interest is only a supporting role.

To put it simply, compound interest means that the profit of each period is not taken away, and the principal of the next period is continued to be invested, which is the concept of profit rolling. Compound interest starts with the bank’s interest calculation. As long as the principal and interest continue to be deposited after the bank’s fixed deposit expires, it can have compound interest effects. However, the current annual interest rate is only about 1%, and of course there will be no explosive growth. So the rate of return is not large enough. What is compound interest? neither.

If the rate of return on investment is 10% per year, and if you invest 100,000 yuan, you can make a profit of 10,000 yuan per year. Even if you invest in simple profit, you can take away the profit of 10,000 yuan per year and you will not continue to invest. 40 years will be accumulated. With a profit of RMB 10,000, the sum of principal and interest at the end of the period is RMB 500,000, which is far more than the compound interest of 1%, which proves that the rate of return on investment is the key, and compound interest only accelerates growth.

Since the rate of return is so important, the return on investment must be as high as possible. The problem is that the higher the rate of return, the higher the relative risk, that is, the greater the volatility. The amounts in Table 1 are all calculated at a fixed rate of return. For the 20% column, a fixed rate of return of 20% every year is actually impossible to achieve, because the actual rate of return will not be the same every year. Equivalent to no risk. Risky assets, such as stocks or bonds, have a higher rate of return because they take risks. Statistically dealing with the different rates of return each year, the average rate of return and standard deviation are generally used to describe the standard deviation. The standard deviation is the degree to which the annual rate of return deviates from the average rate of return. The larger the standard deviation, the greater the degree of fluctuation each year.

Conclusion: Regardless of whether it is a stock or bond fund, you can find the standard deviation data, and you can evaluate the possible future net worth of holding such a target. Compound interest is just to make profits and then invest again. The rate of return on investment is the key, but the higher the average rate of return, the greater the degree of volatility and the higher the uncertainty in the future. Even so, long-term holding can still be rewarded. Next time, don't ask what kind of target has compound interest effect. Trying to find a higher average rate of return is the best strategy.