Probably there isn't any other subject in the (financial) world that gets that little attention, and is that important at the same time... as compounding. Albert Einstein (1879-1955) called it the 'Eighth Wonder of the World'. Warren Buffett has been said to agree with him. And probably you should too!
Compounding is one of the most powerful principles in our universe. Almost everything you see around you is the result of a compounding process.
The human brain is programmed in a linear way. We are too much focused on the short run, on annual or even quarterly returns. Most of us are underestimating the effects our short term focus will have over time.
Our unconscious mind is much more suitable for calculating e.g. the total time of ten biking trips of two hours each, or to say 'run' when we would see a smilodon walking on the street... than to calculate the end sum of a specific amount of money invested growing exponentially at a specific rate, for a certain period of time.
The more you think about compounding, the more you discover its true and remarkable power. Maybe you will even start to see the compounding process as an organic process, as a living creature! Hopefully you will not only see the remarkable consequences, but also act on this knowledge. Quite probably you will - as you see yourself the differences of applying this process to your investments and your life.
Three elements
With compounding there are three components to be distinguished. These are:
1) The amount of money you start with (this doesn't not only hold true for investing!)
2) The returns (annual growth rate)
3) Time (the number of year's available)
First, as you may expect, it's better to start your compounding journey with a considerable amount of money. This was in effect the situation of Warren Buffett or Joel Greenblatt as they started their careers. Because they didn't have much money themselves, they attracted money to their hedge funds they started at a young age. (Buffett probably wouldn't call his early partnerships this way, but nonetheless his fee structure was quite hedge-fund like).
Instead of a big amount to start with, it's also recommended to add money to your compounding-'friend' on a regular basis: this will further 'fertilize' the accumulation process. As I said before, this process doesn't hold true for investing only. It's a process that can be put into action in all kinds of ways. So, after finishing this article, you can read it again... and every time you see 'money', read 'effort' instead!
The second component of compounding lies in the returns. As we have seen before, a high return will bring in wealth over time. And probably this is also the strategy used behind most of the other 'normal' millionaires in the world: they didn't start with a lot of money, but as their stock investments (or their businesses) compounded over time, they suddenly 'discovered' that they too had joined the club of millionaires.
The third and last component of the compounding process is simply time. As your money is doubling every x years, it is very logical that the more time you have, the more often your money can double (for 'effort': think of scalability). So, especially younger people can profit from compounding: they still have a lot of time, a critical resource and component of the compounding formula.
To reach the billionaire status, you actually need all of these components. Although Buffett always told he started with only $100 dollar, he in fact started a partnership with a hedge-fund like fee structure. And with these fees Buffett was able to generate quite an amount of money, in just a few years.
So, from that moment on, Buffett was 'fully loaded' with all the essential compounding ingredients. A lot of money to start with, a long investment horizon (over half a century!) and the knowledge to generated structural, high returns.
And as we look to Joel Greenblatt, and besides of him a lot other billionaires, we see exactly the same: they had all components of the compounding formula in place. Although, in some of these billionaire-cases the starting capital was at the moment just 'a really good idea', the only thing they had still to do was to convert it, into money (or freedom).
The Rule of 72
The 'Rule of 72' is a simple, but nonetheless very handy rule to calculate the number of years it takes to double your money. This is how it works: divide 72 by your expected annual returns and the number of years it takes your money to double follows.
So, if you expect an annual return of 12%, it takes 6 years to double your money (72 / 12 = 6).
With this simple formula you can also calculate the 'required return': if you know how many years you have to double your investments, but don't know the return which is required for that.
For this, you divide 72 by the number of years. If you have 10 years to double your money, you need a 7.2% annual return (72 /10 = 7.2). Only 5 years available? Your required annual return would be 14.4% (72 /5 = 14.4).
Final thoughts
Maybe you don't have a lot of money to start with or don't possess the substitute for it (a really good business idea), but you can still profit from the compounding formula! Also the possession of two of the components of the compounding formula will most likely direct you to impressive results. Just make sure to earn a satisfactory return, add money along the way and let the compounding formula do the rest.
Over time you will really see the value of your investment portfolio accelerate. Personally, I like to compare compounding with a snowball. A snowball rolling down the slope of a mountain. A rather remarkable slope... as the end of this slope is further away then you can imagine!
***
About the author: Hendrik Oude Nijhuis is the cofounder of ww.magicformulastocks.com and is an expert on value investing and a long-time value investor himself. He extensively studied the investment methods of Warren Buffett. More recently, he started studying other exceptional value investors like JoelGreenblatt as well. Hendrik holds an MSc in Public Administration from the University of Twente. The website www.magicformulastocks.com is dedicated to explain private investors (free of charge) why to select stocks on combinations of Return on Capital and Earning Yield. You will learn exactly how to select the most promising and most profitable stocks.
Compounding is one of the most powerful principles in our universe. Almost everything you see around you is the result of a compounding process.
The human brain is programmed in a linear way. We are too much focused on the short run, on annual or even quarterly returns. Most of us are underestimating the effects our short term focus will have over time.
Our unconscious mind is much more suitable for calculating e.g. the total time of ten biking trips of two hours each, or to say 'run' when we would see a smilodon walking on the street... than to calculate the end sum of a specific amount of money invested growing exponentially at a specific rate, for a certain period of time.
The more you think about compounding, the more you discover its true and remarkable power. Maybe you will even start to see the compounding process as an organic process, as a living creature! Hopefully you will not only see the remarkable consequences, but also act on this knowledge. Quite probably you will - as you see yourself the differences of applying this process to your investments and your life.
Three elements
With compounding there are three components to be distinguished. These are:
1) The amount of money you start with (this doesn't not only hold true for investing!)
2) The returns (annual growth rate)
3) Time (the number of year's available)
First, as you may expect, it's better to start your compounding journey with a considerable amount of money. This was in effect the situation of Warren Buffett or Joel Greenblatt as they started their careers. Because they didn't have much money themselves, they attracted money to their hedge funds they started at a young age. (Buffett probably wouldn't call his early partnerships this way, but nonetheless his fee structure was quite hedge-fund like).
Instead of a big amount to start with, it's also recommended to add money to your compounding-'friend' on a regular basis: this will further 'fertilize' the accumulation process. As I said before, this process doesn't hold true for investing only. It's a process that can be put into action in all kinds of ways. So, after finishing this article, you can read it again... and every time you see 'money', read 'effort' instead!
The second component of compounding lies in the returns. As we have seen before, a high return will bring in wealth over time. And probably this is also the strategy used behind most of the other 'normal' millionaires in the world: they didn't start with a lot of money, but as their stock investments (or their businesses) compounded over time, they suddenly 'discovered' that they too had joined the club of millionaires.
The third and last component of the compounding process is simply time. As your money is doubling every x years, it is very logical that the more time you have, the more often your money can double (for 'effort': think of scalability). So, especially younger people can profit from compounding: they still have a lot of time, a critical resource and component of the compounding formula.
To reach the billionaire status, you actually need all of these components. Although Buffett always told he started with only $100 dollar, he in fact started a partnership with a hedge-fund like fee structure. And with these fees Buffett was able to generate quite an amount of money, in just a few years.
So, from that moment on, Buffett was 'fully loaded' with all the essential compounding ingredients. A lot of money to start with, a long investment horizon (over half a century!) and the knowledge to generated structural, high returns.
And as we look to Joel Greenblatt, and besides of him a lot other billionaires, we see exactly the same: they had all components of the compounding formula in place. Although, in some of these billionaire-cases the starting capital was at the moment just 'a really good idea', the only thing they had still to do was to convert it, into money (or freedom).
The Rule of 72
The 'Rule of 72' is a simple, but nonetheless very handy rule to calculate the number of years it takes to double your money. This is how it works: divide 72 by your expected annual returns and the number of years it takes your money to double follows.
So, if you expect an annual return of 12%, it takes 6 years to double your money (72 / 12 = 6).
With this simple formula you can also calculate the 'required return': if you know how many years you have to double your investments, but don't know the return which is required for that.
For this, you divide 72 by the number of years. If you have 10 years to double your money, you need a 7.2% annual return (72 /10 = 7.2). Only 5 years available? Your required annual return would be 14.4% (72 /5 = 14.4).
Final thoughts
Maybe you don't have a lot of money to start with or don't possess the substitute for it (a really good business idea), but you can still profit from the compounding formula! Also the possession of two of the components of the compounding formula will most likely direct you to impressive results. Just make sure to earn a satisfactory return, add money along the way and let the compounding formula do the rest.
Over time you will really see the value of your investment portfolio accelerate. Personally, I like to compare compounding with a snowball. A snowball rolling down the slope of a mountain. A rather remarkable slope... as the end of this slope is further away then you can imagine!
***
About the author: Hendrik Oude Nijhuis is the cofounder of ww.magicformulastocks.com and is an expert on value investing and a long-time value investor himself. He extensively studied the investment methods of Warren Buffett. More recently, he started studying other exceptional value investors like JoelGreenblatt as well. Hendrik holds an MSc in Public Administration from the University of Twente. The website www.magicformulastocks.com is dedicated to explain private investors (free of charge) why to select stocks on combinations of Return on Capital and Earning Yield. You will learn exactly how to select the most promising and most profitable stocks.
