No doubt you have received investment advice to start saving and investing as soon as you can. The reason for this comes down to a very simply yet powerful mathematical phenomena: compounding.
The power of compound interest
Imagine a world where the bank pays an interest rate of 10% in your savings account every year. You put $1,000 into the account and a year later there will be $1,100 sitting there.
You then decide to leave the $1,100 in the bank and a year later there will be $1,210 sitting in your savings account.
If you keep on doing this for 10 years, your initial $1,000 will turn into $2,594.
If you keep on doing this for 20 years, your initial $1,000 will turn into $6,727. That is for twice as long as 10 years but provides you with 2.59x of value.
If you keep doing this for 50 years, your initial $1,000 will turn into $117,391. That is five times as long as 10 years but provides you with 45.25x the amount of value!
Remember, this is for doing nothing besides putting your money into an investment that returns 10% a year.
The important point here is the longer your money compounds, the more exponential your returns will be. Hence, invest early.
Now let’s assume instead of an interest rate of 10%, we use an interest rate of 9%.
If you leave your $1,000 in the savings account for 50 years, you will $74,357. A 1% reduction in the interest rate has meant a 37% reduction in total savings over 50 years. That’s massive.
So compounding gets more powerful the longer you do it and the higher the interest rate.
How this helps the genuinely needy
Instead of looking at a savings account, let’s now look at the economy. And instead of looking at an interest rate, let’s look at the growth rate of the economy.
We now know with the power of compounding, the higher the growth rate in an economy the more exponential the size the economy will be in the long term.
If we assume the economy is growing at 3% per annum, then after 50 years the size of the economy is 4.4x richer than today.
If, however, the economy grew at 5% per annum, then after 50 years the size of the economy is 11.5x richer than today. And it would take just 30 years for the economy to be 4.4x richer than it is today.
So in a world of no inflation and where all members of society get richer when the economy grows (I will discuss these points in later posts), then an increased growth rate means those living below the poverty line will rise above it much faster. And, with time, they will become significantly more wealthy.
Said simply, an increase in the GDP growth rate benefits the genuinely needy substantially in the long term.
How can the GDP growth rate increase?
A significant amount of time will be devoted to how economies grow in future posts however, in short, we generally need to save more to invest more in assets, as opposed to borrowing more to spend on consumption.
When I hear cries like ‘we need a childcare subsidy’, all I hear is ‘we need more middle class welfare so increase taxes; which will reduce incentives for investing so that the economy grows slower so the genuinely needy can suffer in the long run.’
Any policy that puts a choke on growth, hurts the genuinely needy significantly in the long run. That is the trade-off that is being made.
