Albert Einstein loved it and called it the "eighth wonder of the world." Warren Buffett (Trades, Portfolio) also worships it, and he wouldn't be where he is today without its help.
Of course, I'm talking about compound interest, the simple, but vital financial concept that can help anyone become rich.
It is fair to say that this is the most important concept for investors to understand. Even more so than risk. If you understand compounding and how it can transform your wealth over time, you quickly begin to realize that minimizing risk is critical if you want to unlock compound interest's magical qualities.
"Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 écus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the écu 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%." -- Warren Buffett (Trades, Portfolio) writing about the joys of compounding in his January 1964 letter to investors.
You don't have to be Buffett
Most investors will never be able to achieve Buffett-like returns, but this is no bad thing when you factor in compounding. Even risk-free returns can turn small savings pots into significant lump sums over time if left to compound.
Take, for example, a $10,000 investment in a risk-free 10-year Treasury at 2.7%. Left to compound for five decades (assuming the investor can re-invest their funds at the same rate), the initial $10,000 will grow to be worth $38,227.45.
If you add an extra $150 to the pot every month, you could end up with $228,000. Nearly a quarter of a million dollars in today's money by doing nothing but making sure you have $150 to put away every month (for simplicity, I will be ignoring inflation and charges in this article).
Growing returns
In the above example, every 100 basis points of additional return boosts the final sum exponentially. A rate of return of 3.7%, will produce a final pot of $321,000. Meanwhile, 4.7% will yield $460,000, and 5.7% per annum will generate $667,000 after 50 years.
What I am trying to illustrate with this example is the fact that it is not difficult to unlock the power of compounding, and dramatically increase your wealth creation over the long-term. Warren Buffett (Trades, Portfolio) has become a multi-billionaire because he has been able to compound his wealth around 20% per annum. Most investors are not going to be able to achieve the same rate of return. A mid-single-digit annual gain, on the other hand, is quite easy to obtain.
Stocks and bonds
According to portfoliocharts.com, which uses historical data to show the performance of various investment strategies over the long-term, a 60/40 stock bond portfolio has produced an average yearly return of 5.9% since 1970.
This is not using some exotic investment strategy, it is simply buying and holding a basket of stocks and bonds -- a strategy that is easy to replicate using low-cost tracker funds today.
Initially, this return looks unimpressive. However, when we plug it into the example above, we can see the power of compounding at work. $10,000 invested at 5.9% per annum with a monthly contribution of $150 will grow to be worth $720,000 over five decades.
True, this won't make you the next Warren Buffett (Trades, Portfolio), but considering how much time and effort you need to put in to achieve this return (almost none), the performance cannot be ignored.
Compounding will turn even the most straightforward strategy into a wealth-creating machine.
Disclosure: The author owns no share mentioned.
