The Miracle of Compound Interest (and Dividends): A Personal Story
By David Henderson
Last summer, I highlighted famous Canadian whisky producer Sam Bronfman’s claim that the greatest invention in history is interest. I then posted on how to get rich slowly and drew strongly on the idea of compound interest. Of course, I take the principle to mean compound dividends also; that is, investing in stocks and then reinvesting the dividends in more stocks.
In pretty much every economics course I teach, I love teaching the idea of compound interest. I often tell a personal story to illustrate, and some good news happened a year ago that now allows me to give a very different punch line.
In the summer of 1975, when I was just about to move to the University of Rochester as a newly minted assistant professor in the Graduate School of Management (now the Simon School), a friend wanted to borrow $79, $75 for general expenses and $4 to send a UPS package. I was strapped for funds, not yet having received my first pay check from the U. of R. But he really needed it and told me that when he got back to Missouri, he would immediately send me the $79. I lent him the money.
I never heard from him again. I called him a few times but never got a return call. I gave up.
So that story has been a great one to tell because each year I told it, the amount that he owed me increased. In 2014, for instance, the amount he owed me, assuming an average interest rate of 5%, which is conservative (remember the high single-digit and sometimes double-digit rates from 1975 through the early 1990s), was $530. At a more-reasonable rate of 6%, it was $767. I think I could even reasonably argue for 7%.
So laying this out in class was a fun exercise. I started out with “What if he contacted me now and offered to pay me the $79? What’s wrong with that?” Of course, the students got it. What’s wrong is that it ignored compound interest. Indeed, it ignored interest altogether.
Then, about a year ago, I was on the phone with a long-time friend. We happened to be talking about friends in the past and he mentioned John, the guy who owed me. Then he told me that John and he are still in touch and John lives in Kansas City. I told my friend that I don’t have the warm fuzzies for John because he reneged on a deal. My friend asked more and I told him. “I know John pretty well,” he said, “and I’ll tell him that he still owes you. I’ll give him your phone number, if that’s alright.”
That was alright. So a few days later, I got a call from John in Kansas City. He felt bad about what he had done and offered to make amends. So I told him my calculations at 5% and 6%. Guess which one he chose. A few days later, a check showed up. Now my story has a happy ending.