WHY IS THE GAP BETWEEN RICH AND POOR GROWING?

15 December 2021 / Leave a Comment

why is the gap between rich and poor growing?

It’s not very difficult to imagine why the rich are getting richer and the poor getting poorer. Obviously, those with less money tend not to spend the little money on the current account or simply for the fear that the investment they will have to face will only be a way to lose their money.

Taking a very basic example, try to imagine investing $ 20,000 and getting 10% net interest in one year. This means that at the end of the period you will have generated a capital gain of $ 2,000. Instead of pocketing these interests, you decide to invest them. Imagine that for the second year your investment again generates 10% interest. The yield is now calculated on a $ 22,000 basis. This means that your investment will return you $ 2,200, $ 200 more than it would have returned if you had not reinvested the interest.

Now, a $ 200 difference isn’t particularly significant (considering a 10% return is also relatively high). But let’s see what would happen by carrying out the experiment. In the third year, your interest would be calculated on a basis of $ 24,200, generating a return of $ 2,420 (instead of the usual € 2,000 you would have generated if you had not decided to invest the interest). With the same returns, the extra income that you would have obtained thanks to the reinvestment of interest tends to grow over time, becoming an increasingly large portion of your investment. Precisely this is compound interest, an effect that favours investors who decide to remain invested for a long time while also using the returns obtained.

The effect of compound interest, as mentioned, grows exponentially over time. Below you will find a table in which, by way of example, we simulated the result of an investment of $ 20,000, always imagining an annual return of 10%. In the first column, you can appreciate the result by imagining the reinvestment of interest, in the second column you can see the result without reinvesting the interest (simple interest).

Without giving too much weight to the individual figures, the table shows the crucial difference that the interest composition effect can make over time. As can be seen from the graph, the longer the time horizon extends, the more the positive effect of reinvesting this earned tends to become exponential. The growth of the capital with simple interest (in red) is in fact linear: if the invested base is not increased, the returns will be calculated every year on the initial value. On the contrary, the returns generated by the reinvestment of interest grow year after year, soon becoming the main component of the investment.

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