Summary: Power of Compounding
The first rule of compounding: Never interrupt it unnecessarily.
Charlie Munger – Vice Chairman, Berkshire Hathaway
As a young professional, it is likely you have had countless people tell you to start investing now, while you are young. Without context, this well intentioned advice can easily fall flat. However, the truth is their advice couldn’t be more sound. This is because, merely due to being young, you have one of the most potent investment tools at your disposal: time, a key ingredient in leveraging the power of compounding, a phenomenon which Albert Einstein described as “the eighth wonder of the world”.
Understanding Compounding
Although compounding can apply in many facets of our lives, from health and fitness to personal development, in finance it is often referred to in the context of compounding investment income. Compounding is quite simply, growth paid on growth resulting from investment income whether interest or dividends, and can be paid in frequencies varying from daily to annually. The higher the frequency of compounding, the faster the investment will grow. The longer the investment is left to grow, the greater the value it will grow to.
To demonstrate the power of compounding, let’s look at an example of two young professionals. Assume Samantha, a 25 year old investment banker and Hari, a 35 year old engineer, both share the same goal of retiring at age 65 and both estimate they will require $3 million. Ignoring taxes, if they each start at zero, assuming the same 6% rate of return compounded annually, Samantha will have to save $1,573 per month while Hari will have to save $3,078 per month to end up with the same $3 million at age 65. Since Samantha started investing 10 years earlier, she will only need to invest roughly half the amount Hari will need to invest each month to end up in the same position. Samantha’s $3 million retirement costs her $755,040 and Hari’s costs him $1,108,080. The roughly $350,000 difference is an example of how powerful compounding can be when given a little extra time.
Ingredients for Compounding Success
There are a number of key ingredients required for compounding to work its magic:
- Time: The most important ingredient in allowing an investment to compound is time. Being “young” and relatively early in your career, it is possible student debt repayment could be your highest financial priority at this point in time. Even if so, you may still want to consider investing a small amount on a regular basis to take advantage of the lengthy investment time horizon in front of you, which will allow your seemingly small investment today to grow exponentially over time.
- Patience: It can be easy to get discouraged when it feels like our investments aren’t growing as fast as we would like them to but it’s important to keep in mind the real power of compounding comes much later on, making patience critical while we let our dollars go to work for us. For perspective, 99% of Warren Buffett’s wealth was generated after his 50th birthday, and 97% of his wealth after his 65th birthday. Not to mention, Buffett started investing at age 10!
- Discipline: With many competing financial priorities, it can be tempting to tap into our investments to fund enjoyment today at the expense of freedom and flexibility tomorrow. Gaining clarity on what you are aiming to accomplish with your investments and keeping the big picture in mind can help cultivate the discipline required to avoid interrupting your dollars while they are hard at work for you. To quote Charlie Munger, “The first rule of compounding: Never interrupt it unnecessarily.”
Make Your Money, Make More Money
We all want our money to work for us, and leveraging the power of compounding in our investments is one of the most effective methods of accomplishing this objective. By understanding how compounding works and applying its principles to our own unique circumstances, we can substantially reduce the cost of major financial goals such as funding a child’s education, purchasing a vacation property, or becoming financially free from our work. Without compounding, we are limited to funding these goals with only our human capital, exchanging our hard earned wage to purchase the things we want. With compounding, we can minimize the amount of our human capital required to fund these same goals and offset the remaining cost with our financial capital. In other words, our wage comprises only a small amount of the cost, and our investment growth covers the rest.
With a long career ahead of you, time is your greatest advantage. By putting the power of compounding to work, you give your money the chance to grow on its own. Understanding that compounding requires time and that its most powerful effects only appear much later can make patience easier. Staying focused on your long term goals will help you develop the discipline to follow Charlie Munger’s number one rule: never interrupt compounding unnecessarily. Once your strategy is set, the key is simple: invest regularly, stay consistent, and let compounding do the heavy lifting.
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