Compound Interest- Myth or Reality

13 December 2016

In the case of Pam and Sam, compound interest is a myth at best. But more of them below.

Most of us know how compound interest works, but here is a refresher. It starts like this- you put money in the bank- your principal, and it earns interest- the amount the bank pays you to use your money. The interest you earn- the accrued amount,  is added to the original principal and therefore the amount of interest grows over time. Rather simple.

My son and I receive daily emails from Investopedia, and online resource for investing education and financial news. They have a wealth of knowledge on all types of investing. But beware, as with all knowledge a little of it can be dangerous.

A recent morning email contained an article on compound interest. In it Pam and Sam both invested $15,000 at an interest rate of 5.5% compounded annually. Pam invested early, at age 25. Sam invested later, at age 35. At age 50 Pam had over $57,000, Sam just over $33,000. Wow. This certainly illustrates the concept.

But there are problems.  Where did Pam and Sam find an investment returning 5.5% annually? It seems that the investment was pretty stable, perhaps a savings account? And this is where we need a reality check. In the real world, can we find such an investment? It all sounds good on paper. But the truth is that you WILL NOT find this investment opportunity- a stable, fixed 5.5% return over 25 years is a thing of the past. If you are teaching your child about saving, and open a savings account for them, you might get .25%, about 5.25% less than this example. Let’s not even get into the tax burden, and calculating for inflation over those 25 years. We might get really discouraged.

Not only is it important to teach our children about the virtues of putting something away, of saving, but more important are the concepts of discretion, critical thinking, and the benefits of a healthy level of scepticism. So much of what we are told, overtly and in this case, couched in a basic economics lesson, is not true. Children should be taught to understand that taking something at face value may not always be the best decision.

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