The Importance of Compounding

For those readers who know me well, this is a familiar topic. I am a major advocate of encouraging young people to start investing early. The principal reason being that if you start early enough, the prospect of becoming rich is almost guaranteed.

A little known fact is that over the course of the 20^th century, every $1,000 invested in the S&P 500 stock market index, with dividends reinvested, would have become about $19 million. What is even more impressive is that over most of that time, no real work was required by the investor. You could have been skiing, on the beach, or gone to Mars for the 100 years. It was a simple result of money compounding at a rate of 10.4%.[i]

Albert Einstein once said that compound interest is the eighth wonder of the world. To truly understand interest is to earn it, otherwise you may find yourself paying it.

I admit that if you are a Bill Gates, Elon Musk, J.K Rowling, or Sara Blakely you can stop reading here. Those guys and gals made big money as a result of a specific talent and ability. If you are well on your way to inventing the next Microsoft or pair of Spanx, worrying about compounding would be immaterial. But, if you are a mere mortal like me – or you are unsure how your talents may bear fruit, leaving some money aside to compound may be the smartest thing you ever do.

The following table indicates the compounded value of $100,000 at 5%, 7%, and 10% over 10, 20, 30, and 50 years. It is always startling to see how a small investment can add up to significant sums over a period of years.

Years of Compounding	5%	7%	10%
10 years	$162,889	$196,715	$259,374
20 years	$265,330	$386,968	$672,750
30 years	$432,194	$761,226	$1,744,940
50 years	$1,146,740	$2,945,703	$11,739,085

For demonstrative purposes only; rates are not guaranteed; depends on investment choices.

If you can manage to save and invest $100,000 in your twenties and leave it untouched, by 50 you could have anywhere from $500,000 to $2 million put away. If you are able to wait until your seventies, it could grow up to $12 million. These are huge payoffs from work that was completed before your 30^th birthday.

An obvious question is, if getting rich is so simple, why don’t we have billions of wealthy people walking around? The answer is that while it is simple, it is not easy. It requires personal sacrifice and discipline. Woody Allen was only too accurate when he said “the only thing standing between me and greatness is me.”

We all have short-term wants and desires. Unfortunately, humans are hard-wired to overweight short-term satisfaction. To get rich through simple compounding, you have to be prepared for two things. First, compounding involves short-term sacrifice. You can’t spend it and still save it. Realize that you are your most important asset. Pay yourself a small salary before spending your money anywhere else.

Second, my method to riches is very boring. Conventional wisdom would suggest when you are young you can afford to take big exciting risks with your investments. This could not be more false. I often describe my view of wealth as having the freedom to spend my time doing what I want to do, not what I have to do. Why risk that freedom by speculating? Only at a young age can you guarantee a wealthy future from an average rate of return.

Let me finalize my point while adding some culture into this discussion. In a 1964 letter written by Warren Buffett, he noted that King Francis I of France paid 4,000 ECUs in 1540 for Leonardo da Vinci’s Mona Lisa. That is equal to about $20,000 in those days. If Francis had been more level-headed and listened to me, he may have instead put the funds into a reliable, albeit much more boring, 6% investment. Left untouched by his descendants, today that sum would be worth $22,213,749,069,696,600. That’s $22.2 quadrillion dollars. For reference, the Mona Lisa is insured by the Louvre for a modest $800 million. My boring investment would have out earned the world’s most famous and expensive painting by 28 million times.

In the coming weeks and months I plan to write more on this topic. I have my theory and mountains of data and academic studies to back it up. Read Richard Russell’s Rich Man, Poor Man. He will also tell you that simple compounding is a safe road, a sure road, and fortunately anybody can do it. In the meantime, if you have any thoughts, questions, or criticisms, I would be glad to hear from you.

¹Data collected by Robert Shiller, Yale University. http://www.econ.yale.edu/~shiller/data.htm

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