Investing For Devs — Power of Compounding Interest

80% of all day traders quit within the first two years on average

Contrary to popular belief, you can beat the market by doing nothing with the power of Compound Interest.

Compounding Interest is analogous to a snowball on the top of a snowy hill. As the ball rolls down the hill, it gets bigger. In fact the bigger the surface area of the ball the more snow it adds on and the bigger it gets.

What is Compounding Interest?

Compound interest is adding the interest you earn on investment back to the principal at the same interest rate so you can earn more interest over time.

Let’s say I have $1000 invested at 5% interest rate annually.

At year 0, I have $1000.

At year 1, I will have $1000 + $1000*(0.05) = $1050.

At year 2, I will have $1050 + $1050*(0.05) = $1102.5.

At year 3, I will have $1102.5 + $1102.5*(0.05) = $1157.63

and so on.

Experiment with future returns with the simple Python program below. Try varying the return rate, initial investment, and the time period.

def compoundinterest(return_rate, initial_investment, time_period):
  returns = initial_investment
  print ("You invested $", initial_investment, "at",return_rate, "% with annually compound interest")
  for i in range(1, time_period):
    input("Press enter to continue")
    print ("Year", i, "you will have", returns, "+", returns*return_rate, "=", returns+returns*return_rate)
    returns = returns + returns*return_rate
compoundinterest(0.06, 1000, 5)

Let’s compare this to Simple Interest where the interest earned on the investment is not reinvested and the principal amount stays the same.

Let’s say I have $1000 invested at 5% interest rate annually.

At year 0, I have $1000.

At year 1, I will have $1000 + $1000*(0.05) = $1050.

At year 2, I will have $1050 + $1000*(0.05) = $1100.

and so on.

Experiment with future returns with the simple Python program below. Try varying the return rate, initial investment, and the time period.

def simpleinterest(return_rate, initial_investment, time_period):
  for i in range(time_period+1):
    returns = initial_investment*return_rate*i
    print ("Year", i, initial_investment+returns)
simpleinterest(0.06, 1000, 5)

Comparing returns — Simple vs. Compounded

This is linear(simple) vs. exponential(compound) growth at work.

How can we use this to our advantage?

Time Period > Higher Return Rate. The time period is the biggest contributor to the amount of return you get back.

The return rate of course still plays a part. An example, the difference between 5 and 6% interest is 1000 dollars after 10 years. The gains at 25 years and 7% are slightly lower than 30 years at 6%. But the risk you would take on might not be worth it for the 25 years.

Recommendations

1. Start early. The longer the time horizon, the higher the growth of returns.

2. Be consistent. Look for investments with steady growth over time. That’s the basis of value investing.

The best way to gain wealth is to become the snowball

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