Wednesday, October 20, 1999

An Easy Compounding Lesson

By BooChickie

The quickest way I can think of to teach compounding is based on a fable I heard as a child about a poor wise man (a poor Foolish man?) who was to be given payment by a king for services rendered.

When asked by the king how he wished to be paid, the Foolish man asked for a chessboard, and asked the king to give him one penny on the first square of the chessboard, two pennies on the second square, four pennies on the third square, eight on the fourth, and so on, doubling the amount of each previous square until all the squares on the chessboard were covered. The king agreed, thinking that he was getting off cheap -- it was pennies, after all.

But the king ended up owing the Fool quite a pretty penny. I used this example to explain compounding to my son: Take one penny on the first of the month and double it daily for four weeks. We wrote the sums down on paper faithfully every day. His eyes (and mine, I must say) grew wider and wider as we headed into the second week:

Day 1: $0.01

Week 1: $0.64 (He was NOT impressed at this point.)

Week 2: $81.92 (He's beginning to see the light -- I'm glad it's just a paper exercise!)

Week 3: $10,485.76 (He's spending it -- I tell him to wait, it gets better!)

Week 4: $1,342,177.28

We decided to diversify and invest a pittance in a new form of transportation after first calculating how much it would cost to pull that pittance from the portfolio by running a parallel computation with and without the withdrawal. I submit that doing this is the easiest way I know of to demonstrate the concept of compounding. It worked for my family!

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