Sunday, December 28, 2008

Part 1: Compounding interest – understanding the basics by looking atthe evolution of computer memory

What qualities would you look for in an ideal employee? Dependability, always works hard 24 hours per day seven days a week, no time off, only needs initial guidance toward becoming self sufficient, gets better over time, eventually pays you to be your employee. All of these qualities are found by making your money work for you as the ideal employee by using compounding interest. Compounding is a key investor tool that most accredited investors know well and use to their advantage whenever possible to increase wealth. This article will begin a series on compounding. To view the next article in this series on compounding, click on: "Visualizing the compounding effect."

When compounding is your enemy
In my last article series, I wrote about credit card debt and how they are designed to maximize compounding interest paid by the debtor to the credit card companies. The article describes how making minimum payments on a $2,000 purchase can end up costing you $8,183.46 over 26 years of payments at 19.99% interest with $6,183.46 of that being interest paid to the credit card company. I guarantee the credit card companies fully understand the strength of compounding interest and how it adds to their profits. Now lets learn how compounding interest can work for you and not against you as it does with credit cards and other loans.

A simple analogy for understanding compounding
Lets first look at a simple example you may all have heard – computer memory. When I started college in 1980, I can remember 4k memory cards were the thing. That means the memory card had 4,000 transistors to retain memory. Then they came out with 8k memory. When 16k memory came out, we thought that was amazing. We thought no one would need more than that in a desktop computer - remember the TRS-80 computer, also known as the “trash 80?” The computer companies didn’t stop, and went on to create an astounding 32k, then 64k - remember the Commodore 64?, 128k, 256k, 512k, 1 meg, 2 meg, 4 meg, 8 meg, 16 meg, 32 meg, 64 meg, 128 meg, 256 meg, 512 meg, 1 gig, 2 gig, and now you can buy a 4 gigabyte memory card for less than $100. A 4 gig memory card has 4 billion transistors! So, in the course of less than 30 years, we have increased memory on computer chips from 4,000 transistors to over 4 billion. That is an 18 fold increase. What if these were dollars instead of memory transistors? Would you like to have those types of returns on your investment over 30 years?

In actuality, the actual number of transistors does not come out in even thousands. The industry has used rounding to the nearest thousands, millions, and now billions as a way to more easily label the memory size. I will carry on with the rounded numbers for simplicity.

Visualizing compounding over time
Look closely at the above memory growth pattern. Did you notice that while the memory chip size doubled between chips, the number of transistors grew exponentially over the 30 years? From 4k to 8k, the transistors increased by 4,000. From 8k to 16k, the transistors increased by 8,000. From 16k to 32k, the transistors increased by 16,000. Therefore, when you look at the transistor increases between chips you see the following pattern:

Old chipNew chip# Increase in Transistors
512k1 meg512,000
1 meg2 meg1,000,000
2 meg4 meg2,000,000
4 meg8 meg4,000,000
8 meg16 meg8,000,000
16 meg32 meg16,000,000
32 meg64 meg32,000,000
64 meg128 meg64,000,000
128 meg256 meg128,000,000
256 meg512 meg256,000,000
512 meg1 gig512,000,000
1 gig2 gig1,000,000,000
2 gig4 gig2,000,000,000
4 gig8 gig4,000,000,000

Notice that doubling the number of memory transistors between the first two chips of 4k to 8k only increased the number of transistors by 4,000. However, doubling between 4 gig and 8 gig increased the number of transistors by 4,000,000,000. Both sets of chips were simply doubled from the previous version, but the number of transistors increased between the “double” was dramatically different after nearly 30 years of technological advances in the ability to shrink the size of each transistor. Had you stopped at any of the first five doubles, you would have never reached the tremendous compounding effect reached in the 30th year. This is very much true of compounding interest and compounding investments. The “interest” or compounding rate differs for each type of investment over time, but they all can work for you over time through the incredible power of compounding to increase your wealth.

Compounding is how to make money work for you as the ideal employee that never tires, never complains, always works, continues to get better, becomes self sufficient over time, and can end up paying you through your retirement years. View the next article in this series on compounding: "Visualizing the compounding effect."

Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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