Since You Asked

What would Einstein make of bonds?

“I learnt about Albert Einstein.”

“Aha! A fascinating fellow. And an economist, too, in a strange way. Einstein once declared the most powerful force in the universe was compound interest.”

“Really, Dad? Ms Cartwright said that was the strong nuclear force.”

“Ms Cartwright can be awfully literal sometimes. The point is, compound interest is a tremendously powerful force for accumulating wealth. Imagine a savings account that pays 10 per cent interest per year. At the end of the first year, you’ve got £110 in that account. And then you start earning interest on the interest you’ve already accumulated: 10 per cent of £110 is £11. So at the end of the second year, you’ve got £121.”

“So you’ve earned £21 in two years? That doesn’t sound like the most powerful force in the universe to me.”

“You can also be awfully literal. I think you are spending too much time in the company of Ms Cartwright. Allow me to demonstrate.”

[Flips open computer and taps into a spreadsheet.]

“Now. This spreadsheet represents two possible financial futures for you. In this column, you begin investing £100 a year from the age of 10 until the age of 21. Then you stop investing. In this other column, you squander your pocket money and only begin investing at the age of 22, but you continue to pay £100 a year until you reach the age of 65. Now observe this remarkable thing: you earn more from investing for just those eleven years, early in life, than from more than 40 years of investing starting just a little bit later. In fact, you earn more than twice as much. Is that not a most impressive demonstration?”

“While you’re on the computer, Dad, could you check that Einstein quote on the internet? It doesn’t really sound like the kind of thing he would have said.”

“Do not allow yourself to be distracted. Let us now move on from the topic of Einstein and simply focus on the matter in hand: compound interest.”

“I understand. I suppose I should find myself a bank account paying 10 per cent interest, then. Which one would you suggest, Dad?”

[There is a pause. Father rummages around on his desk, with no apparent aim.]

“Dad, I think I heard someone say that there was a new inflation-linked certificate that paid the equivalent of 9.67 per cent interest for higher rate taxpayers. That’s almost 10 per cent.”

“Ah yes. That’s true.”

“So if I invest £100 a year in one of these certificates until I’m 21, will I then be able to stop investing completely?”

“Hm. Possibly not. These certificates actually only pay 0.5 per cent on top of the rate of inflation.”

“And is compound interest at 0.5 per cent the most powerful force in the universe?”

“Arguably not.”

“Then why say that it’s worth nearly 10 per cent to a higher-rate taxpayer?”

“Because that’s the rate of interest you’d need to earn to pick up the equivalent of the 0.5 per cent. If you earned 10 per cent, first you’d have to pay tax on that, which would bring it down to 6 per cent. Then you’d need to subtract the rate of inflation, which is more than 5 per cent.”

“It sounds to me that we should find a savings account that pays 10 per cent after tax and inflation, in order to take full advantage of the most powerful force in the universe.”

[Another pause. The aimless rummaging begins again.]

“Dad, we need a savings account paying more than 25 per cent interest. Is there one?”

“Not at the moment, dear.”

“Anything close?”

“No. Actually, the banks are grumbling that they can’t begin to compete with the 0.5 per cent interest, after tax and inflation, on offer from the government.”

“I’m not sure what your demonstration of compound interest is supposed to be teaching me, Dad. Is there any way to get a 10 per cent return?”

“You can take more risks. But the thing about this savings bond is it’s backed by the government and is therefore completely safe.”

“I see. Is that because governments always pay back their debts?”

“You are being literal-minded again.”

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28th of May, 2011Since You Asked • Comments off