The 8th Wonder of the World
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it” – Albert Einstein
Regardless of how much it’s talked about, compounding is truly one of the most underappreciated miracles of finance.
Early on in my career, the parable of the Rice and the Chessboard really helped to illustrate for me the power of compounding. As the legend goes, a faithful servant made one seemingly simple request to the king, “For my faithful service, please give me a single grain of rice tomorrow, then double this allotment each day for ever square on the chessboard.” Sixty-four squares translating to sixty-four days. This innocent ask was granted by the king, and little did the king know that he just committed to providing his servant with 461 billion metric tons of rice. More rice than is produced annually in the entire world.
A more modern example of this phenomenon is the “would you rather” riddle. Would you rather have $1,000,000 today or a penny doubled daily for thirty days? At first glance, the million dollars seems attractive, but that truckload of pennies over a month would equate to over $10 million or ten times that of the other offer.
These are simply illustrations of how exponential growth works. What I often analogize to is the snowball rolling down the hill, the bigger it gets, the more snow it picks up, and the bigger it gets. Clients are often in disbelief when I project what their future wealth will look like at the end of life. The numbers just seem too big and unbelievable. It’s like I’d have a better chance convincing my client that I had Bigfoot over for dinner last night. Yet, this is just the power of compounding at work.
Now, let’s look at compounding from the perspective of an accumulator, a decumulator, and a new investor.
For the Accumulator…
As of this writing, Warren Buffett is the 5th richest man in the world. When Buffett was 65, his net worth was around $3 billion. A surprising little tidbit is that the now 94-year-old Buffett has accumulated 98% of his net worth after the age of 65.
How is that even possible?
This is another illustration of how compounding works over time and why it’s so important for an investor to leverage the power of compounding. When you first start saving, your contributions are really important – they are the baseline or foundation of your portfolio. Over time, those cumulative contributions begin to become overshadowed or dwarfed by the compounding growth that’s happening year over year.
Here is a simple graph to illustrate this point:
This represents an investor saving $10,000 annually over 30 years and earning a 10% return. In year one, the investor’s contribution represented 90% of the portfolio value; by year 30, that same investor’s cumulative contributions only represented about 16% of the total value. Hence, this is the same phenomenon for which 65-year-old Buffett’s $3 billion net worth became pocket change compared to his $158 billion net worth today.
No one had a better view of this magical compounding in Buffett’s life than his longtime friend and partner, Charlie Munger. Perhaps this is why we used to hear him often pleading with investors, “never interrupt compounding unnecessarily.”
One seeking to accumulate wealth must (1) understand the power of compounding and (2) use this power to their advantage. Yes, saving is important, but just as important is long-term, uninterrupted investing.
For the Decumulator…
One disservice our industry has done is to give investors the impression that retirement is an investing finish line. There is a message out there that you save as much as you can, you patiently invest until you hit that “enough” number, and then you victory lap from there on out.
What I mean by victory lap is that you no longer prioritize long-term growth, but rather veer towards investments that feel “safe.” For most accumulators, stocks are what fueled the growth of their nest egg, so I find it odd that decumulators are often abandoning stocks once they hit retirement. I believe this is a major mistake.
I am not advocating for a 100% stock portfolio but rather emphasizing that compounding is just as important for a decumulator as it is for an accumulator. A decumulator’s greatest fear is running out of money, so allowing one’s portfolio to grow and outpace inflation becomes crucially important.
As we saw with Warren Buffett, compounding does some of its most amazing work when applied to an already sizeable nest egg. This is why I have always advocated for an Expense Based Planning approach (see: Expense Based Planning – Revisited) that allows investors to retain those “risk assets” that help amplify compounding.
Essentially, you want to opt into higher rates of return so that the growth of the portfolio outpaces the growth of your spending, which in time shrinks your withdrawal rate – the percentage you withdraw from your portfolio to cover your expenses. Of course, risk needs to be accounted for, too, which I cover in the Expense-Based Planning link I provided above.
For New Investors…
Between friends from church or children of clients, I get the opportunity to talk to new investors often. One of the best things I can do for a new investor is to really instill the power and importance of compounding.
New investors should save early and often. New investors should focus on long-term investments, and new investors should do their best to ignore the daily swings of the market.
I remember in my senior year of high school, economics, I was shown the saving records of two investors. One started saving at the age of 18 and stopped saving after 8 years, while the other investor started at age 26 and saved for 40 years. Both investors saved $150 a month and earned a 12% return. The big difference? One started early, and the other saved for a longer period (8 years of saving versus 40 years of saving). Surprisingly, the investor who saved $150 a month from 18 to 25 had nearly $500,000 more than the investor who saved the same monthly amount for 40 years starting at age 26.
Again, early and often is the advice. Compounding loves time, so the more time you give it, the more magic it can make.
You’ve Just Gotta Experience it for Yourself…
When I think about some of the incredible places I have been in my life, I think about walking the Great Wall of China, admiring the Swiss Alps in winter or enjoying the views in Big Sur where the redwoods meet the coast. Lots of fond memories, and with eyes closed, I can recapture some of the imagery. Now, I could describe these things to you, and I could even show you my photo reel, but nothing would compare to you seeing these places for yourself.
Perhaps this is why compounding is so underappreciated. Maybe even an article like this just can do it justice. In that case, I would encourage you to experience it for yourself. Be intentional about saving, patient with your investments, and sit back to enjoy the view and beauty of compounding.
Until next time, friends…
