Last Updated on April 26, 2022 by Rational thinking
“Compound interest is the eight wonder of the world. He who understands it, earns it….he who doesn’t, pays it”
Presumably, Albert Einstein said the words above, and likewise, Benjamin Franklin said that time is money. Unfortunately, we seem to forget these very simple principles when it comes to most decision making – be it learning, investing or in everyday life. Compounding comes in many fields as long as you’re agnostic, adaptive, open, truthful to yourself and a student for life. This way you compound both knowledge and wealth.
Why are we so slow in recognizing the effects of compounding? Most likely because the benefit of compounding is not immediate, but gradual. A boat sailing one degree off-course will over short distances hardly be noticeable, but over long distances, the mistake compounds and the boat misses its destination completely.
Compounding requires time and delayed gratification, often lots of it. Most people would rather have one marshmallow today than two in the future. Furthermore, we tend to think in linear terms and not appreciate the effort that can be sustained by thinking long-term.
The aim of this article is to illustrate investment-compounding with some simple examples. Put short, you need three variables to make money investing: capital, return and time. In this article, you will learn about the importance of return and time.
The third element, capital (and how to get it), is not covered in the article. Capital is of course very important, after all, it’s the first seed you need in order to create financial wealth. But, as you will learn in this article, time is in most cases more important than a bigger amount of capital.
CAGR is a term you often read about when you study investing and returns. It’s an abbreviation for compound annual growth rate and is used to “measure” the rate of growth. It’s not an arithmetic mean, but the geometrical return from the beginning to the end result (and is always different from the arithmetic average).
What is compounding?
Compounding is best illustrated by the snowball-effect, something I believe most of us have experienced: as you roll a small snowball in wet snow it grows bigger for each turn.
Compounding in the investment world works exactly the same: if you invest 100 at a 10% return, you have 110 at year’s end. If you don’t reinvest those 10 you earned, then the return in year 2 is also 10% and you have 120. However, if you reinvest those 10 you earn, you make 110 times 10% in year 2: 11 (the interest on the interest). That means you have 121 after two years, not 120 as you would in a non-compounding scenario:
|Year||Return %||Accumulated capital|
But if you reinvest the previous year’s return, it grows much faster:
|Year||Return %||Accumulated capital|
The difference is best visualized with a graph:
By now you have probably realized that the main factor for long-term financial wealth is how you invest the “earnings”/returns, not the initial principal. Because of the snowball effect, it’s the marginal rate of return you get on the reinvested capital that is important. I have covered this topic before in an article about dividends/marginal rate of return.
What happens if you let those 100 compound over many years?
10% over 30 years accumulates to almost 1 800 dollars (starting with 100). What happens if you manage a 10% return over 50 years?
After 50 years the initial 100 has grown into 10 600 dollars. The first 30 years was an eighteen-bagger, while the last 20 years (from 30 to 50 years) doubled your initial capital 88 times. Presumably, Warren Buffett has made 99% of his wealth after he turned 50, and now you can clearly understand why. (The only official biography about Buffett is called The Snowball (written by Alice Schroeder).)
Obviously, the return you get on your capital is paramount. The difference between 8 and 10% might not seem like a lot, but over time it makes a lot of difference:
100 invested at 10% accumulates to almost 1 800, while an eight percent return only returns 1 000. Clearly, over 30 years the end result is 80% more wealth if you compound at 10% (compared to 8%). The difference magnifies as time pass.
As you probably have understood by now, the amount of time spent with a positive return is perhaps equally important as the return. Let’s run another example that better illustrates the importance of time:
Let’s assume you invest 10 000 annually for 30 years with a 10% return. The graph looks like this:
You have saved 300 000 during the period, but your capital has grown to about 1.8 million after 30 years.
Let’s change the scenario: You save 10 000 in year one, but then nothing in the next ten years. After 10 years your income improves and you manage to save and invest 15 250 annually for the next 19 years, thus saving an equal amount as in the first scenario (300 000). However, the market returns 12% in the last 20 years, not 10%. The difference between the two examples looks like this (blue is the first example and red is the second):
The 12% return in example two can’t recoup the lack of savings in the first ten years. You would need more years to cover the deficit.
The earlier you start saving and investing, the better. Even small monthly amounts could potentially add significantly to your pension.
Time and return are important – sometimes even more important than the amount of capital you save.
Equally important is that you can compound in all aspects of life. Avoid a short-term mindset and bias, accept delayed gratification, and accept that learning and investing takes time.