Updated: Feb 5, 2019
This is a really quick blog post about Compound Interest. This is a personal favorite example of mine and I'll use it again in the following post when talking about Dollar-Cost-Averaging, so I wanted to introduce it you guys here. If there are any Golf lovers/players our there reading, you'll love this. Even if you're not, this example is still very useful in understanding the power of compound interest. So let's begin. Allow me to set the scene:
Two very good friends Micheal and Jim go play a round of golf (18 holes) at Micheal's golf club. Micheal initiates the conversation
Micheal: "Hey Jim, let's make this round interesting."
Jim (Nodding his head): "OK. What're you thinking?"
Micheal: "Let's put a wager on each hole. We'll start off small and go from there, cool?"
Micheal: "The first hole is going to be worth 10 cents. And then we'll double the value of each
hole subsequently thereafter. So, for example, hole 1 will be 10 cents, then hole 2 will be 20 cents, hole 3, 40 cents, and so on and so forth.
Jim: "Are you sure?
Jim: "That's really not much money to start with, but ok."
Micheal: "Oh it'll be fun! Trust me."
So Micheal and Jim play their round of golf in this fashion doubling the value of each hole as they play. An hour or so goes by and the boys reach hole 6. At Hole 6, Jim looks at Micheal with a bored look:
Jim: "Micheal, this is not as much fun as you said it was going to be! We've literally been playing for pennies! Are you sure you don't want to make this more interesting?"
Micheal: "Trust me Jim, just be patient. I promise things will get more interesting."
Jim shrugs his shoulders, sighs, and continues playing his round of golf with Micheal.
A couple of more hours go by and the boys walk up to the 12th hole and suddenly Jim stops and looks at Micheal, astonished:
Micheal: "You alright, Jim?"
Jim: "Oh. My. God."
Jim: "Oh my god!!!!"
Micheal: "Everything Alright?"
Jim: "You sly devil..."
Micheal : "What're you talking about?"
Jim: "You know exactly what I'm talking about!"
Michea (smiling)l: "...Ah, yes. You get it now."
Jim: "That is F&#$ing amazing!!"
Micheal: "I know right?!"
Jim: "I didn't even see it coming! And then WHOOSH! Out of nowhere..".
Micheal: "I know, I know. Most people don't see it. That's why I told you, be patient."
Jim: "Things just got very interesting."
Micheal: "Yes they did...You could even say they got Compound interesting."
They both have a laugh and continue on with their game. (The Corny Jokes write themselves, people)
So what did Jim realize at Hole 12? He realized that the dollar amount of the pot that accumulated over the first 12 holes reached a point that when they start doubling it, they're going to be playing for some serious cash.
If you look at the table below, I have showed you what will happen to the original 10 cent wager from hole 1 all the way up to hole 18.
As you can see in the table, hole 12 is worth about $200. Doubling from there on out results in some serious cash that Jim and Micheal are playing for. In fact, hole 18 is worth $13,000!!!! Starting at 10 cents and ending at 13 grand is a growth rate of 1300%! Holy Sh!t, Batman!
Now, if we study the table more closely, you'll see that for the first 12 holes (2/3rds of the course) the size of the pot grew by only about $200. But the last 6 holes, the pot grew by more than $12,000. That's because the nominal amounts (dollar amounts) are growing with each subsequent hole. Doubling 10 cents is not worth as much to us (in terms of buying goods and services out in the world) as is doubling $200. But you see, even starting with small amounts in the beginning and being patient over time can benefit you in the long run. Hole 12 is known as the critical mass point where the subsequent rounds of compound interest will bring you in some serious cash.
I think this is a really great example of not only understanding the value of compound interest, but also of patience--something we all need to remind ourselves to have more of in all parts of our lives. For the layman investor, patience is your friend. It's your best friend. Your greatest lover (Too much?). But it's true, patience is just as important to the layman investor as is the more technical concepts.
Once again, I want to stress that Compound Interest is just a part of your arsenal for successful long-term investing. We gotta add another key ingredient to the mix--Dollar-Cost-Averaging. I'll talk about that in the next blog post! Stay tuned....