Compound interest is the interest that is earned on the principal sum of an investment. Interest is then earned on the initial amount and the reinvested interest. This is often referred to as earning interest on interest. The effects of compound interest can best be illustrated by the telling of an old Indian fable…
The legend goes that a wise old sage was making his way through India. The king at the time was an avid chess enthusiast and often challenged visitors to his kingdom to a game of chess. As to get the wise old sage to accept the challenge, the king offered the sage any reward he so wish.
The wise old sage considered the kings offer and replied by simply requesting that if he should win the game that a single grain of rice be placed on the first square, 2 grains of rice on the second square, 4 on the third, 8 on the fourth, 16 on the fifth and so on and so on.
The king, thinking the request was a modest one, quickly agreed to this and the game of chess was played. The wise old sage defeated the king. Upon losing the chess match, the king being a man of his word requested his advisers to bring a bag of rice to pay the wise old sage. After a week of counting, the advisers to the king returned to inform the king that there was not enough rice in the kingdom to repay the wise old sage.
The king had failed to see how powerful the effect of compounding could be. There are 64 squares on a chessboard, for the king to have been able to fulfil the wise old sage’s request the king would have needed to give 18,466,744,073,709,551,615 grains of rice to the wise old sage.
Investors looking to maximise the benefit of compound interest, should remember that time is the magic ingredient, and that compound interest works best for the investor given the time to grow exponentially.
