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“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
~Warren Buffet
“The first rule of compounding is to never interrupt it unnecessarily.
~ Charlie Munger
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
~ Albert Einstein (alleged quote; I have my doubts)
Did Albert Einstein really call compound interest the eighth wonder of the world? That’s debatable. What’s not up for debate, however, is that compound interest is indeed wondrous and every investor should know how it works.
Compound interest is very simple; think of it as “interest on interest.” It also has a more technical name: exponential growth. If an investment grows 5% annually, then $100 will grow into $105 dollars after the first year. After the second year, that $105 will grow to $110.25 – the extra $0.25 can be attributed to the interest earned on the interest from the first year.
Now before you dismiss the significance of 25 cents, think about larger sums of money. And think about longer periods of time. This is where it gets good.
If you have an investment that grows 8% annually, how much will it have grown after 9 years? The answer isn’t 72% (8% x 9). The answer is 100%, all due to the wonders of compounding. After another 9 years of 8% growth, your investment will have grown another 100%, meaning you’ll have four times the money you started with. After another 9 years, it’ll be eight times your starting balance, and so on:
- $10,000 (starting balance)
- $20,000 (after 9 years @ 8%)
- $40,000 (after 18 years @ 8%)
- $80,000 (after 27 years @ 8%)
This is an example of the “Rule of 72,” which is a simple way of figuring out how long it takes an investment to double in value (and a great illustration of compounding in action). If you take your rate of return and divide it into 72, the resulting number is (roughly) the number of years it takes for your original investment to double. Keep in mind the Rule of 72 assumes all income is reinvested and ignores any tax implications (we’ll come back to taxes in a moment).
Compound interest can work against you as well. Think about your mortgage for a moment. Most traditional mortgages DO NOT compound the interest. If you look at a mortgage amortization table and do the math, you’ll see that interest is calculated each month on the unpaid balance, and then immediately zeroed out by your monthly payment. No interest is carried over from month-to-month.
But if you think back to before the financial crisis of 2008, you may recall the easy availability of a financial time bomb known as the “negative amortization” loan. This type of loan allowed borrowers to vary their monthly payments. If a payment didn’t cover the monthly interest charge, the unpaid interest got added to the remaining balance of the loan. Going forward, you’re then PAYING interest on previously unpaid interest. Adding insult to injury, many negative amortization loans had variable interest rates which rose dramatically after the first few years. A lot of borrowers – some reckless, but others just inexperienced – got into serious trouble after years of making low payments on negative amortization loans.
So how can you make compound interest work in your favor? Let’s refer back to Charlie Munger’s quote at the beginning of this post: don’t interrupt it. In a noisy world filled with highly volatile investments that occasionally produce spectacular short-term returns, investors are often tempted to make frequent trades in their portfolios. Chasing the latest investment fads is commonplace, and we’ve all done it. But let’s be honest, by the time you hear about an amazing investment, the easy money has already been made. The FOMO experience (“Fear of Missing Out”) is quite powerful, and it often leads people to make ill-timed decisions.
And this is where taxes come in. If you frequently trade in a regular (non-IRA) brokerage account, every profitable trade is taxed, meaning some of your proceeds go to Uncle Sam (and to your state, if you live in one of the 43 states with an income tax). This obviously lowers your account balance, leaving you with less dollars to reinvest. So frequent trading creates an environment where you interrupt the compounding process (unnecessarily) and pay extra taxes (unnecessarily)…all for the privilege of chasing the latest investment fads which won’t necessarily live up to the hype.
(Of course, there are many legitimate reasons to sell an investment. My comments here are aimed at those who may frequently trade because they get bored with a particular holding, or perhaps are not willing to endure periods of lackluster performance. And full disclosure: I’m guilty of both!)
One of my favorite finance writers is Morgan Housel. He recently wrote an article noting that 97% of Warren Buffett’s wealth came after his 65th birthday:
Yes, he’s a good investor. But a lot of people are good investors. Buffett’s secret is that he’s been a good investor for 80 years. His secret is time. Most investing secrets are.[1]
He goes on to say (emphasis mine):
Once you accept that compounding is where the magic happens, and realize how critical time is to compounding, the most important question to answer as an investor is not, “How can I earn the highest returns?” It’s, “What are the best returns I can sustain for the longest period of time?” That’s how you maximize wealth.1
So maybe it really is all about time. Yes, there are other aspects to successful investing, but don’t overlook how uninterrupted compounding can produce amazing results for surprisingly little effort. You don’t have to be the smartest person in the room, you just have to be in the room. And you have to be comfortable hanging out there for a while, in both good times and bad.
Sometimes the hardest thing to do with your investments is…nothing. A well-diversified portfolio is usually boring, occasionally underperforms and definitely doesn’t generate headlines. But if you’re a disciplined investor who can tune out the noise and handle the occasional boredom (not easy to do), and if you can continue to invest in both good times and bad (also not easy), you’ll end up creating the ideal environment for maximizing your wealth over time.
By the way, if you’re not familiar with Morgan Housel, he’s a excellent writer who regularly publishes articles at https://www.collaborativefund.com/blog/. He offers thoughtful insights on financial topics, and his writings are easily understandable to geeks and non-geeks alike. He’s helped sort out my thinking on a variety of topics, and I highly recommend taking some time to review his work.
(Note: I have no financial relationship with Morgan Housel or The Collaborative Fund. He’s just very, very good.)
[1] https://www.collaborativefund.com/blog/standing/