Don’t Underestimate The Power Of Compounding

The power of compounding is truly intriguing. If you are somewhat familiar with investing, you may have an idea of how important this is to your financial future. Time plays a key role here, as well as the compounding rate of your returns. Your start time matters significantly considering time is your best friend. The more time you have, the better.

A dollar invested at a 10% return will be worth \$1.10 in a year. Invest that \$1.10 and get 10% again, and you’ll end up with \$1.21 two years from your original investment. The first year earned you only \$0.10, but the second generated \$0.11. You may think this is cool, but who wants to earn those small amounts of money? Well hold on- Let’s look at one more realistic example. Think like this: Increase the amounts and the time involved, and the benefits of compounding become more pronounced.

Compound interest can be calculated using the following formula:

FV = PV (1 + i)^N

FV = Future Value (the amount you will have in the future)
PV = Present Value (the amount you have today)
i = Interest (your rate of return or interest rate earned)
N = Number of Years (the length of time you invest)

Let’s say you have \$10,000 and you want to invest for 10 years at annual compounding rate of 9.9%.

FV = 10,000( 1+0.099)^10

FV = \$25,702

So in 10 years you almost tripled your money! Bravo! Pretty good right? If you are still a skeptic, maybe this image will change your mind.

This is Warren Buffett’s performance versus S&P 500 since 1965, when he originally started the partnership. Notice that his average annual compounded gain was 19.4% versus only 9.9% on S&P 500 side.

Let’s see how would Buffett do with your \$10,000 with his average return.

FV = 10,000(1+.194)^10

FV = \$58,890

Impressed yet? No wonder he is one of the greatest investors of our time. With this rate of return and millions of dollars invested in different businesses you get Berkshire Hathaway. A conglomerate holding company whose revenues reach around \$280B and whose assets are worth almost half trillion dollars.

We briefly talked about three important goals that you as an individual investor should have engraved on your mind. Now I would like for you to focus on the image above, specifically years: 1966, 1969, 1973, 1974, 1977, 1981 etc. Anything you noticed so far? Common themes?

If not- let me help! During years mentioned S&P 500 had a negative rate of return, while Warren managed to stay afloat. Even more recent years like 2001 and 2008 ( former dot com crash and latter housing crash) show that Berkshire lost less money than S&P 500. And we are talking significantly less. In 2009 we have (37.0) vs (9.6). In 2001 (11.9) vs (6.2). In 2002 Berkshire beat S&P 500 by 32.1% because the market was still shocked from the dot com bubble explosion. These numbers prove the point of minimizing the risk at all costs!

How did Berkshire do it? Well in the 2000’s they simply stayed away from dot com companies. Their business model didn’t really follow the suit Warren was after, even though people made fun of him on “missing the biggest investing opportunity of all time”. I wonder who got the last laugh on that one.

Key takeaway: Minimize your risk by investing in financially strong companies who have a good business model and an extreme brand recognition- at a fair price of course!