Albert Einstein was asked what he thought the greatest human invention was, and after a moment of thought he replied, “Compounding interest.” The concept is extremely important to understand but can be hard to explain.
The conversation below is a good way to trick your friends out of some money, and it uses compounding interest to your advantage. Try it out, and let me know how it goes.
FRIEND: Hey Dan, you’re good with money. How does compounding interest work?
ME: Let’s make a bet
FRIEND: Okay, what are we betting on?
ME: How about a peanut-eating contest?
FRIEND: Um, sure. Who eats the most in five minutes wins?
ME: No, let’s make it more fun than that. We’ll take turns for 10 rounds, and whoever lasts the longest wins. But each of us will have a different challenge.
FRIEND: What are the challenges?
ME: Whoever goes first eats 10 peanuts in the first round, and each round, he adds 10 peanuts to the total. So the first person would eat 10 peanuts in the first round, 20 in the second, 30 peanuts in the third round, and so on.
FRIEND: Ok, got it. What does the other person do?
ME: The person who goes second starts with 1 peanut and doubles his total each round. So he would eat 1 peanut in the first round, 2 in the second round, and 4 in the third.
FRIEND: Alright, I get it. How do we pick?
ME: Well, since it’s my game, I’ll let you pick the challenge you want.
FRIEND: Yes! I’m going to start with the 1 peanut. You’re going down!
ME: Fine with me. How about the loser pays $100?
FRIEND: You’re on!
ME: Done. But before we start, we need to make sure we have enough peanuts to last the whole game. If I take 10 + 20 + 30…I’ll need 550 peanuts.
FRIEND: Oh, man. I’ve got this in the bag!
ME: For you, I need to add 1 + 2 + 4 + 8…you’ll need 1,023 peanuts.
FRIEND: What?! That’s not fair! I’ll have to eat, like, double the peanuts to beat you.
ME: Hey, you picked it. Are you forfeiting?
FRIEND: Well, no, it’s just not a fair fight.
ME: Look, I let you pick what challenge you wanted. It’s not my fault you picked the compounding interest path.
FRIEND: Huh? This isn’t a bank loan! That’s not how compounding interest works.
ME: Sure it is! Doubling your peanuts every round is growing at a 100% interest rate. The same would happen if you let your credit card debt grow at 17% a year. It’s small now, but it’ll be terrible later if you stop paying it.
FRIEND: Is that also why everyone tells me I should have started saving for retirement ten years ago?
ME: Yeah, pretty much. Anything that grows by a percentage makes a curve rather than a straight line. Making 3% on your money isn’t much, but 3% on $100,000 is still an extra $3,000 that you didn’t have to work for. Whether it’s 3%, 5%, or 10%, all compounding interest grows in a curve, and the good part is at the end.
FRIEND: Is that why saving money feels terrible at first but turns into millions after decades?
ME: You got it. But tonight, you’re going to get sick on peanuts and I’m going to win $100.