It is difficult to argue that there is a more powerful force in the world of investing than compound interest. Once described as the eighth wonder of the world by Albert Einstein, the principle of compounding has helped every single billionaire get to where they are today. As Warren Buffett (Trades, Portfolio) once said, "My wealth has come from a combination of living in America, some lucky genes, and compound interest."
The problem with compound interest is that it is so difficult to understand, and you only really see the benefits of this wonder of the world after several years. It takes time and patience to reap the rewards of compound interest, which, unfortunately, most investors are just not willing to wait for.
Compound interest is much more than just a mathematical equation. It should be the ideal that underpins an entire investment strategy.
The core of an investment strategy
Over the long term, meaning about 20 or 40 years here, just 1% or 2% of extra annual returns can add up significantly, thanks to the benefits of compounding. For example, a $10,000 investment compounded at 5% for 40 years would be worth $70,400 at the end of the sample period. The same initial investment compounded at 6% annually for four decades would be worth $103,000 at the end of the sample period.
The difference in compounding returns means investors have to think about what assets they choose to include in their portfolios, and the degree of risk they take on.
In his 2005 personal finance book, "Unconventional Success: A Fundamental Approach to Personal Investment," David F. Swensen highlighted the fact that between 1926 and 2003, $1 invested in S&P 500 stocks expanded 2,285 times, "while bonds produced a 61 multiple, and cash, an 18 multiple." Based on this example, you could be forgiven for thinking that the best way to compound your wealth over the long term is, without a doubt, to invest in large-cap stocks.
This is true to a certain extent, but it fails to take into account your own personal investment preference. If you cannot deal with the volatility of investing in stocks, there's no point because compounding works both ways. As Frank Martin once explained:
"The following is an immutable, and what should be perceived as sobering, law of compounding. A single 100 percent loss can wipe out an entire lifetime of cumulative gains. Compounding is not an equal-opportunity mechanism. Its rewards and penalties are asymmetrical."
And Adam Smith:
"The joys of compounding are there if you keep your stake growing, but all you need have is one year in which you give back half, and your program, at the same growth rate, must stretch out years and years longer."
Seth Klarman (Trades, Portfolio) has noted many times that the best investors start with assessing risk first, and then move on to potential rewards. And considering the impact losses have on compounding, this makes a tremendous amount of sense.
If you have money and patience, a simple index fund investment will show you the benefits of compounding clear if held for the long term, but these benefits can be quickly eroded if there's no strategy behind the investment. Overtrading or chasing investment fads can quickly eliminate profits from compounding.
The bottom line
To summarize, compounding is the most potent tool investors have available to them, but to make the most of this wonder of the world, investors should make use of it as part of an investment strategy. A strategy should be designed to help compounding work its magic by focusing on risk and your personal risk preference. As Chuck Akre (Trades, Portfolio) once said:
"The bottom line of all investing, whether it be Aunt Tillie's C.D. or Uncle Jack's venture fund, is compound rate of return."
Disclosure: The author owns no share mentioned.
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