Compound interest is the most powerful force in the universe.– Albert Einstein
Is it really? Let’s dissect it.
Compound Interest is earning interest on interest in addition to just principle. Therefore, it is a great way to accumulate your wealth.
What are the rules of compounding?
There are four components of compounding. They are.
- Initial Investment amount
- Additional periodic contribution
- Interest rate / Rate of compounding
- Number of years to compound
The final amount is directly proportionate to all four. Meaning, if any of those four variables increase, your final amount will increase.
As a regular stock investor our goal is to obviously increase our wealth. So, we will try to find the things that we can control to maximize our wealth.
1. Initial Investment Amount
Like us, most of the retail investors will not have a huge initial wealth to start investing with. This is really not in our control. Unless you inherit some generational wealth, we will start with a small sum.
Here is a little wisdom from Charlie Munger on the initial investment amount.
The first $100,000 is a bitch, but you gotta do it. I don’t care what you have to do – if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000.Charlie Munger
Let’s say you manage to save $100,000 and if you compound that $100,000 for 55 years at 10% rate, you will get $18.9 million.
However, if you compound just $1,000 for 55 years at 10% rate, you will get just $189k.
Therefore, you have a huge advantage if you have a greater sum to start with.
2. Additional Periodic Contribution
Additional periodic contribution is in our control. If you earn bigger amount and have low expenses, you are capable to increase monthly/annual contribution.
Additional monthly/annual contribution to your investment is really a lifestyle choice. It plainly depends on the nature of your personality and character. It does not necessarily depend on how much you earn, but rather on how much you save.
Earning $60,000 a year and saving 30% of it i.e. $18,000 is way better than earning $100,000 a year and saving 10% of it i.e. $10,000.
See the difference below. The same assumption (compounding $100,000 for 55 years at 10% rate) with just $1,000 monthly added contribution increased the final amount to $41 million, which is more than double the final amount without any monthly contribution.
It helps if you are a frugal person and do not care much about material wealth. Contrary to that, if you value brand and expensive lifestyle, you are not designed to contribute much periodically to wealth accumulation.
3. Rate of Compounding
The interest rate or the rate of return is in our control.
So, instead of compounding $100,000 for 55 years at 10% rate if you compound it at 20% rate, you will get an astonishing $3.6 billion dollar. Yes, correct. It is not a typo. It is billion with B. This is outrageously large.
By the way, if you do not know much about Warren Buffet. He was a normal person like you and I, who compounded his wealth at 20% rate for 55+ years. Currently, he is worth more than $100 billion.
Yes, it is possible! If you are smart and hardworking as Warren Buffet.
4. Number of Years to Compound
The third variable comes naturally. If you start early and live long enough, everyone has this variable on their side. If you start investing in mid twenties, and live until eighths, you will have around 55 years to compound. 55 years is more than enough to see the magic of compounding.
Now, lets assume you only have 30 years instead of 55 years to compound your $100,000 at the same 20% rate, you will only get $37 million versus $3.7 billion.
That tells us that the latter years of compounding is so very important for wealth accumulation.
“The first rule of compounding is to never interrupt it unnecessarily.”Charlie Munger.
You and I are not Warren Buffet, so lets get to some realistic compounding rate of 10%. If you somehow interrupt the compounding process, you will have to pay the Uncle Sam his cut of your hard work. If you have to pay 25% tax on your return on year 30 and then compound the remaining amount at the same rate, you will only get $31 million versus $41 million.
If you do in and out in the compounding process, your return will be even worse. So, staying at it is very important.
2.7 million compounding from year 30 till year 55 i.e 15 years at 10% rate yields you $31 million.
The same $100,000 compounding for 55 years at 10% without any interruption gives your $41 million.
So, let’s not interrupt compounding unnecessarily.
In summary, combining all four variables i.e. the huge initial investment, additional periodic investment, better than market rate of return and long years for compounding provides you an exceptional wealth. Let’s take advantage of this great force.