While compounding is an important concept to understand in wealth creation for the long term, relatively few people have a grasp of its power. What’s the secret of building long term wealth? There are different answers, and you probably have your own views, but I’m sure there will be a common thread to most replies: compounding.
Financial compounding is the process by which an investment’s returns, from capital gains or dividends or both, are reinvested to generate additional returns over time. It’s like a snowball being rolled down a hill: it starts off small with not much extra snow added, but the bigger it gets the more snow it gathers. The further the snowball goes the more powerful the effect, which is why time plays such a big factor in compounding. The effect is unimpressive at first but can turn into something spectacular as the years progress. Einstein is said to have called it the eighth wonder of the world.
Why is compounding so important to investors?
The world’s most successful investors attribute much of their success to the power of compounding. Most famous of all is Warren Buffett who once stated, “My life has been a product of compound interest.” Buffett is more than 90 years old, so he has been in the game a long time, and this has been more important to his wealth creation than his renowned stock picking.
Very importantly, Buffett has also largely avoided the traps many investors fall into, being patient with his purchases, and buying assets with a ‘margin of safety’. For him that’s meant owning reliable businesses with hard to copy business models and significant deep-rooted value – think Coca-Cola or Apple. By buying at a fair price he has limited his long-term losses, and this is very important for the compounding process. Anything that interrupts it, such as stopping investing or suffering a heavy loss that can’t be rebuilt, undermines it. The snowball stops in its tracks.
While the power of compounding is such an important concept to understand when building wealth for the long term, relatively few people have a grasp of its power. The human brain has few problems with linear trends but finds exponential ones much harder. If you fold a paper 50 times, it goes to the moon and back more than ten times.” A counter-intuitive result, and purely theoretical as it can’t physically be done, but the point is valid.
The same logic can apply to investing. Folding a piece of paper results a doubling in thickness each time. Doubling your money in an investment can be done but it’s not easy. However, there is a catch. If you reach too far for higher returns you can come unstuck. Doubling your money in a year would probably involve taking a very high level of risk, most probably casino-like. However, doubling your money over ten years is much more attainable. You need a return of just over 7% a year. And at 20 years? Well you would be very disappointed if you hadn’t achieved it.
What’s striking with the compounding effect is how patiently accruing modest returns can lead to excellent long term results.