Compound Interest: The Secret To Riches

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The Power Of Compound Interest

“The Eighth Wonder of the World”

"My life has been a product of compound interest" Warren Buffett

Intro

Why would Albert Einstein insist that one of the most powerful forces in the universe, indeed the Eighth Wonder of the World, is compound interest?

Well, because it’s true!
Compound interest expands money…. infinitely. It grows investments exponentially. It harnesses the power of time, itself.
No quick fix, get rich quick idea or secret formula can produce the result of compound interest.

Consider the ancient Chinese tale of the chessboard and the grain of rice:

The Emperor of China loved the game of chess…so much so that he rewarded the inventor with one wish.

The inventor seized upon the opportunity and “invented”
compound interest, on the spot. He replied that he wanted one grain of rice on the first square of the chessboard, two grains on the second square, four on the third and so on
through the 64th square. Little did the Emperor realize the power of this seemingly modest request.

But by the time he would reach the last square, he would need 18 million trillion grains of rice--more than enough to cover the entire surface of the earth.

The clever inventor did not gain all the rice in China; he lost his head. But he did give us the power of compounding in the process.

Let’s make this more practical…..say you start on February 1 with only a penny saved.

Let's say you double it every day. So you have 2 cents on February 2 and 4 by February3. How long do you think it will take to have $1 million?

Did you say 100 years, 10 years, and 1 year?

Starting with a penny and doubling every day, you would have over$1 million – $1,342,177.28, to be precise – in only 28 days!

And if it were leap year…..well, the month of February alone would produce an unbelievable $2,684,354.56!

DID I GET YOUR ATTENTION???

Simply stated, compounding interest refers to the fact that the interest you receive will be calculated not only on the principal amount that you invested, but also upon prior interest amounts added to your investment.

That is, the interest you earn will also add interest and the interest upon interest upon interest will keep adding to your principle, FOREVER...

Table Of Contents

The Laws of Money

Compound Interest: Fundamental Component In The Laws of Money

If people were taught it at school as part of a money management unit, I doubt that as many of us would be relying upon Social Security for retirement support as we have today.

Nobody expects you double your money (or your rice) every day.

However, the power of compounding will double our holdings over time.

What period of time?

To Answer the question, we must look to one of the lesser known mathematical facts about compounding: The “Rule of 72.”

The Rule of 72

The Rule says that compound interest will approximately double your money within a calculable time period: that period is determined by dividing the interest rate you receive into 72.

The result will be the period, in years, that it will take to double your money.

Earn 8% interest, and your money will double in 9 years (72/8=9).

Earn 10%and your money will double in 7.2 years (72/10=7.2)

Obviously, the power of compound interest is most relevant today with regards to to managing our personal finances.

Nothing beats simplicity.  Nothing beats doing nothing!  And believe it or not, that is exactly what compound interest is all about.

Let the future take its course.

Let's image the following scenario:

If one of your ancestors, i.e grandfather has simply  set around $100 in a trust account in 1937 for you, well, you would be Rich today. Wealthy

To add some spice to the scenario, and assume that the principle and the interest  had been untouched for the next 81 years, you would have amassed a fortune.

If the trust fund earned 10% per year which is reasonable given the fact that this is approximately the average rate of return of the stock market, how much money would
you have today from that initial $100 investment?

let's See.... With all we now know about compounding, the answer is no longer unbelievable.

The single act of starting a trust fund in 1937 for $100 and then doing nothing else would produce a legacy by the end of 2017 of over $225,000.

From a mere $100 gift from your grandparents you could draw down that account upon retirement in the form of annual payments that would virtually match or even surpass what you can expect from your retirement.

Secure Your Kids Financial Future & Well Being

What about the next generation.

Consider that in 1950, when they were beginning their adult life in earnest, if your parents put away $1,000 in a mutual fund at a 10% rate of
return,

when they retired in 1997 that $1,000 would have grown to $251,637. That assumes they never saved an additional penny for the rest of their lives.

All of this required only a single act - a beginning seed, like a grain of rice on a single square of a chessboard.

 

Now begin considering how you can harness the power of compounding by taking additional action, by fueling the fire and stoking it periodically.

How?

Fuel it by adding to the initial investment and stoke it by increasing the rate of return.

If starting in 1950 your parents had added another $1,000 every year into the same stock mutual fund, they would be very rich today. That stock fund would be worth $2.75 million.

Your parents could have a more than sufficient income just by living off the interest from this account and they could leave the entire $2.75 million to you.

What’s that? Your parents did not do that for you?

Well you can do that for your children and grandchildren, and the government will help!

That’s right.

Today, you can leave an IRA or other tax deferred account, to your children, which defers the tax throughout their lifetime.

This is called the stretch out IRA. It is the most powerful tool in all of generational wealth building.

Combine it with compound interest and you will build a dynasty

Steady Growth

Harnessing The LEVERAGE of Compound Interest

Steady Growth + Adding Small Increments = Wealth!

What If Rates Drop?

What About Uncertainties?

So far, all of these numbers are based upon a rate of return of 10%.

This may seem like a relatively high rate, considering that in all of the examples, there was no tweaking, no looking for a higher rate, no work of any kind.

But this rate is not an anomaly and it is correct.

A researched carried by Jeremy Siegel, author of Stocks for the Long Run (McGraw Hill, 1997),  concluded that from the day the New York Stock Exchange first opened for business, through the end of 1997, the average annual rate of return on stocks has been more than 10 percent.

Mr. Siegel  further researched the probability of fluctuations and found that  that there has never been a 40-year period in American history when the markets have deviated significantly from that long-term trend.

And, You CAN DO BETTER THAN THAT!

Say What?

If you can manage to earn any rate of return better than that, and the power of compounding can appear nuclear.

It is impossible! No Way?

Yes, it is.

But there is catch....

Well, just look at the now famous case of Ted Johnson, a UPS Driver who never earned more than $14,000 per year.

He plowed every penny of savings he had back into UPS stock, and when he reached the age of 90 he shocked his relatives and friends by announcing that his net worth was a cool $70 million.

The important thing to remember about the power of compound interest is that it depends for its effectiveness upon only one thing: leaving the interest alone and letting the interest earn interest.

All of the other factors, the rate of return and the amount of time, merely affect the bottom line.

Without the “let it ride” factor, the power melts away to nothing.

Just look at an easy example, comparing the power of compounding to the modest result of simple interest, where the earned income is not held but is withdrawn.

It is a simple investment of $10,000 at a high rate of return, 15%, held for 15 years.

Here's how much money it would make when at the end of 15 years given both scenarios:

Simply by re-investing his interest, and making use of the power of compounding, the result is $48,871 in additional income.

Put another way, if we had chosen to have the interest paid out we would have tripled the initial investment after 15 yrs.

By reinvesting income, we are able to multiply it 8 times!!

The longer the period of time, the greater the benefit. Below is the comparative table for the same investment with 5 more years:

Compound Interest Requires Patience & Discipline

You need the proper attitude to make this work.

I cannot emphasize this enough; attitude is everything in doing nothing and getting rich.

We are trained early in our lives to think that the overnight success is the real success.

Nonsense!

This notion is very dangerous to your wealth and well-being.

Once again, the real secret to investment riches is to be patient with your strategy over a long time frame.

The Follow the Fed investment strategies are designed to do just that.

The power to compound interest allows anyone in our prosperous nation to become financially free given sufficient time, but there are a few things that can give you The Edge:

1. Invest what disposable income you have
2. Invest at a reasonably good interest rate (i.e. well above the rate of inflation)
3. Start as soon as possible to put time on your side
4. Use an investment strategy that does not require you to pay ridiculous fees and commissions that only reduce your returns. For example, the Follow the Fed strategies require only low cost Index Funds and/or ETFs.

A twenty year old starting out investing just $100 per month at a return of 15% should, by the time they retire at age 60, have accumulated a sum just over $3,100,000.

Can you cultivate the right attitude and be patient?

If you can, you will be rich.

Don't put it off – the key to compounding is time.

If you wait until you're 30 to start doing this, you'll only have around $700,000 by age 60 instead of $3,100,000.

If you're 40 or 50 and you're reading this, don't be discouraged.

You're obviously not going to be able to derive the same benefit from compounding compared to a 20 year old, but start now anyway – the sooner you start, the better off you'll be.

What Professional Investors Have To Say About Compound Interest?

“It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled” Warren Buffett, Partnership Letter 1964

"Over time, a two-percentage-point advantage makes a huge difference to returns." Ralph Wanger

Compounding is the magic of investing” Jim Rogers

"The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling"  Seth Klarman

“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things” Charlie Munger

“Long-term compounding is an investor’s best friend, so why get in its way” Guy Spier

"Compound interest, described in a phrase of disputed origin, is "the eighth wonder of the world". Wonder or trick, it has build great fortunes, and you can use it to get richer" Ed Thorp

"The sooner you start, the more compounding can do for you.  If, beginning at the age of twenty, you sock away just $100 a month in stocks, and your portfolio compounds at 10%, which is what stocks have provided historically, you will be a millionaire when you retire at sixty-five"  Ralph Wanger

"A mere 3% annualised edge will produce a 2.4-fold advantage over a 30 year period - the salient lesson that compounding teaches - the power of a long runway"  Allan Mecham

"Compounding is one of my favorite words. Compounding is powerful. Warren Buffett did not become one of the wealthiest men in the world by suddenly striking gold in a single highly successful investment, but rather by compounding the value of Berkshire Hathaway at a 20 percent or so rate for 45 years. If an investor can achieve an average annual return of 20 percent, then, after 45 years, an initial investment of $1 million will appreciate to $3.6 billion. Wow! " Ed Wachenheim

"All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering" Peter Cundill

“Einstein called compounding the eighth wonder of the world and our mission is to harness this dynamic for our investors benefit." Christopher Begg

“The tyranny of negative compounding returns maybe the hardest lesson that far too many investors never master” David Rolfe

"Over the years a lot of very smart people have learned the hard way that a long string of impressive numbers multiplied by a singe zero always equals zero.  That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others" Warren Buffett

"In business and also investment, success is measured through the compounding of a series of returns.  Mathematically, the biggest risk to a compounded series of returns is large negative numbers or even a single negative number, if large enough.  Take however many spectacular annual outcomes and multiply them by just one zero and the answer is of course, zero"   Marathon Asset Management

“And never forget that anything times zero is zero. No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn to pumpkins and mice”  Warren Buffett

 

"Striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal.  Many people think of us as a “value investor” and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor." Chuck Akre

"It's hard to believe that over the last 100 years the S&P 500 rose 273-fold, but adjusted for dividends it rose 18,520-fold." Morgan Housel

"The great thing about compounding is that in order for it to be a thousand bagger it was only a five hundred bagger just halfway before there, and a 250 bagger and so on"  Chuck Akre

 

"I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days.  What do I hear? Penny.  So that's the question.  Compounding our capital is what we're after, that's what makes it a great investment for us.  What's the value of compounding? Well the answer in this case is simply astounding.  Double a penny a day for 30 days gets you, who knows, $10 million, $737,000 change"  Chuck Akre

"Compounding should be the overarching mission of investing activities for capital with a multi-year time horizon" Christopher Begg

"Consider the Indians of Manhattan, who in 1626 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 362 years the Indians have been the subjects of cruel jokes because of it - but it turns out they may have made a better deal than the buyers who got the island. At 8 percent interest on $24 (note: let's suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short of $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion. Give Manhattan the benefit of the doubt: that $28.1 billion is the assessed value, and for all anybody knows it may be worth twice that on the open market.  Either way, the Indians could be ahead by $29 trillion and change.. What a difference a couple of percentage point can make, compounded over three centuries"  Peter Lynch

"Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large! For instance if, Sam Scared made 100% a year and put it in a sock and Charlie Compounder made only 1% a year but reinvested it, Charlie's wealth would eventually exceed Sam's by as much as you please.  This is true even if Sam started with far more than Charlie, even $1 billion to Charlie's $1."Ed Thorp

Last Words

Whatever Happens, Set Funds Aside and Don't Touch It!

The secret to long term investment success is compounding.

I think a large part of the investment industry have lost sight of what really is the goal of investing.

It is fair to say that If you would ask people what they are trying to achieve when they start to invest  -current manage their capital -  the answer is likely to be something along the lines of ..  "grow my money".  

The average individual investors out there isn't trying to beat some index or to deliver attractive risk-adjusted returns.  

Most people want to make some money and build nice nest egg for when they retire, which means they need to protect and grow their capital at an attractive rate above the rate of inflation.

To achieve your objective, you must understand the concepts that will help reach your goals

It is crucial that you spend the time learning the key concepts. Once you understand the sheer power of compounding and the impact a few extra percentage points of annual return can have over a lifetime, you will change your focus.  

An investor must make sure they do not deviate from what matters and underestimate what compound can do for them.

The key enemy to compounding is losing capital and that is why preserving capital is such a focus when it comes to investing.  

And this knowledge puts an end on complete misguiding concepts and unrealistic returns on capital.

Understanding compounding dispel myths and shows why the notion of doubling your money every year for example is absurd.

Unless you are wiling to lose everything!

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