"The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling."
-- Seth Klarman (Trades, Portfolio)
If I had to pick a favorite topic in finance, it would have to be compound interest.
Compound interest is both one of the most difficult to understand and fascinating concepts in finance. It is difficult to understand not because it is a complex idea, but because the human mind struggles to think in a compound way.
Instead, our minds are geared to think in a linear way. For example, it is easier to understand the sequence 1, 2, 3, 4, 5 than 1, 1.2, 1.4, 1.8, 2.2, 2.7, 3.3, 4, 4.9, 6, 7.3 etc (that's 1 compounded at 20% p.a. for ten years).
Nevertheless, understanding this concept is vital to be a successful investor. It is essential to understand both the negative and positive effects that compound interest can have on your wealth.
Positive and negative effects
Compounding can turn a relatively small sum into a substantial nest egg over the long-term. But, it can also work against you if you are in a lot of debt. Furthermore, one significant setback can eliminate years of hard work and compounding.
This is why it is crucial to stay out of debt, particularly high-cost debt, and avoid any permanent capital impairment.
Buffett's advice
Warren Buffett (Trades, Portfolio) figured out the benefits of compound interest from an early age. It might be going too far to suggest that his understanding of this critical financial concept has been the single most significant factor behind his success over the years, but it has been fundamentally important. There's no getting away from the fact.
Buffett understood that wealth compounds over time. The longer he could compound his wealth, the richer he would become. So, he started saving and investing as early as possible. As he wrote in his 1964 letter to investors of the Buffett Partnerships:
"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."
These early years were critical from a savings perspective.
For example, let's say you start saving for retirement at 50 years of age and plan to retire at 60. You invest $1,000 in the stock market for ten years. The market returns 10% per annum during this period. At the end of the decade, your investment will be worth $2,710.
However, the Oracle of Omaha started investing in his mid-teens. A 15-year old that invests $1,000 in the stock market, and doesn't touch this money for the next 45 years, would end up with a retirement fund of $88,350.
Time to start saving
These are only back of the envelope calculations, and ignore things like fees, additional contributions, inflation and taxes, but they clearly show the impact compound interest can have on your wealth over the long term.
That's why it is essential to start investing as soon as you can, even if it is only $10 or $20 every month. Thanks to the power of compound interest, these small sums will compound into significant figures over the long term.
If you are going to learn one lesson from the Oracle of Omaha, the power of compound interest should be it. His advice on investing and managing companies is second to none, but a good understanding of compound interest is the foundation of any investment strategy. Without it, the whole strategy could come crashing down.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Buffett: Every Investment Should Be Simple
- Warren Buffett Explains His Moat Principle
- Warren Bufett: No Need to Be Jealous of Lottery Winners
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