It’s a Bird … It’s a Plane … It’s Compound Interest!

Published on March 2, 2010

Note to Readers:  This article is part of an occasional series on personal finance topics.

The dwindling number of kids who still collect comic books have another reason to persist in the hobby after news that the first Superman comic book recently sold for a record $1 million.  Of course, a combination of  rarity and preservation is what delivered the big payday and few other books are likely to be worth anything close to $1 million.  Furthermore, trying to get rich by purchasing collectibles is not generally the best path to wealth.  What this story does illustrate is the massive power of compound interest and the opportunity to convey this information to young people effectively.

10 Cents to $1 Million?  Just compound at 25% For 72 Years…

Most readers of The Rational Walk are well aware of the power of compound interest, yet how many of us automatically think in terms of compounding?

Warren Buffett thinks in exactly this manner as a brief comment made during his recent CNBC interview makes clear.  Many of us think like this automatically for shorter timeframes.  But for some reason, hearing about a $1 million price for a comic that sold for 10 cents gets categorized in the “amazing trivia” category rather than being an obvious illustration of compound interest.  As Mr. Buffett noted, the $1 million is the result of compounding ten cents at approximately 25% for 72 years. What about inflation?  Ten cents in 1938 is the equivalent of $1.54 in 2010 dollars which brings the real return down to 20.4%.

To be sure, compounding any amount of money at a 20 to 25 percent rate over seven decades is extremely unusual.  Ten cents compounded at 15 percent over 72 years would only amount to $2,346, possibly the cost of a one week vacation.  At 10 percent, the result would be $95.56, maybe enough for one night in a decent hotel.  And at 5 percent?  Not enough for a fancy cup of coffee at Starbucks with an ending value of just $3.35.

Powerful Lessons

Compound interest is simple mathematics, but few individuals have a grasp of the power this provides over short or long term periods.  The statistics described above regarding the enormous variance of results based on seemingly small differences in compound interest rates is not intuitive for most people.  Nevertheless, the Superman comic example provides a great example that can illustrate the power of compounding to younger people who have the most to gain by harnessing the power of compound interest.

Unrealistic examples such as compounding ten cents at 25 percent over a lifetime are obviously not expectations that should be set.  However, even looking at much more modest assumptions can be powerful.  For example, if a teenager earns $5,000 in each of the four years of high school and invests the $20,000 in a Roth IRA earning a real return of 8%, the end result will come to approximately $839,000 of purchasing power at age 65 (assuming $5,000 invested at ages 15, 16, 17, and 18).  Even using a more conservative 6% rate results in a $338,000 nest egg.  That’s a huge dent in the retirement needs of most individuals, all from working in high school and putting the money into productive investments.

Money Without Education = Disaster

Obviously, the last thing most teenagers think about is retirement, but parents who have teenagers with earned income can fund a Roth for their kids.  However, doing so is not enough to result in these positive outcomes.  In order to prevent the funds from being wasted on Spring break in college, young people need to understand the power of compounding, particularly the fact that the dramatic increase in ultimate value will not be readily apparent for many years.  Assuming that the Superman comic appreciated at 25 percent per year steadily (even though it did not), that ten cent comic would only have been worth slightly under $1,000 thirty years ago.  That’s still a dramatic outcome starting from ten cents, but $1,000 isn’t $1 million. That result required the final thirty years of compounding.

The flip side of compound interest is apparent when examining the evils of debt.  Debt turns the magic of compound interest into an enemy.  This is even worse because interest rates on most revolving debt actually can approach 25 percent.  Individuals carrying any debt other than conservatively financed housing on fixed rate terms are courting disaster.  This includes  auto loans.  There is no good reason for individuals to purchase cars on credit.  It is far better to save what would have been the monthly payment for several years and pay with cash (harnessing the power of compound interest to help along the way).

Personal finance topics, and particularly the power of compound interest, should be a requirement to graduate from high school.  Sending kids into the world without this basic knowledge is the same as letting them get behind the wheel without driver’s education.  The amazing story of Superman #1 is a good opportunity to emphasize these important lessons.

It’s a Bird … It’s a Plane … It’s Compound Interest!
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