Once described as the eighth wonder of the world, the miracle of compounding is one of the most important concepts in investing. If you don't understand how compounding works and how it can accelerate your investment returns, I highly recommend you spend some time researching the topic right away; you won't regret it.
Compounding is the workhorse of the investment landscape. Over time, compounding does the heavy lifting for your investment portfolio so all you have to do is find the best ideas, and over time, as long as you don't suffer a permanent capital impairment, the magic of compounding will accelerate your wealth creation. For example, when Warren Buffett (Trades, Portfolio) was 50, he was only worth around $200 million – almost nothing compared to his $75 billion fortune today. This growth has been partly due to his stock-picking acumen, but mostly the growth has been thanks to the magic of compounding. Below are some quotes from well-known investors which sum up how compounding can work for you:
The magic of compounding
“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 (Trades, Portfolio), Partnership Letter 1964
"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% 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 points can make, compounded over three centuries." – Peter Lynch
"The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling." –Seth Klarman (Trades, Portfolio)
“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 (Trades, Portfolio)
“Remember the power of compounding. You don’t need to stretch for returns to grow your capital over the course of your life.” – Walter Schloss
"The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine." –Warren Buffett (Trades, Portfolio)
"My wealth has come from a combination of living in America, some lucky genes, and compound interest." –Warren Buffett (Trades, Portfolio)
“Investors that do the best, and have done the best, are those that stay and compound at above-average rates over the long term.” –John Paulson (Trades, Portfolio)
“We’ve going to compound it at a reasonable rate without taking unreasonable risk or using leverage. If we can’t do this, then that’s just too damn hard.” –Charlie Munger (Trades, Portfolio)
"Remember that accumulated knowledge, like accumulated capital, increases at compound interest: but it differs from the accumulation of capital in this; that the increase of knowledge produces a more rapid rate of progress, whilst the accumulation of capital leads to a lower rate of interest. Capital thus checks its own accumulation: knowledge thus accelerates its own advance. Each generation, therefore, to deserve comparison with its predecessor, is bound to add much more largely to the common stock than that which it immediately succeeds." – Charles Babbage
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