The Awesome Power Of Compounding

This week will be a simple blog, yet it could be one of the most important things you’ll ever read. And while the concept may seem rudimentary, it is extraordinarily powerful. This is how true wealth is created; not by excessive trading or via arcane investment strategies. No, true wealth is built by compounding your money over time. It’s really as simple as that.

For the purposes of this illustration, we’re assuming two college friends, each of whom just turned 21. Investor A (Bob) decides to spend his extra money on new clothes and parties each month for the ensuing seven years, while Investor B (Mary) lives more conservatively and instead starts each year by putting $2,000 in her discount brokerage account.

Next, we’ll assume a compounded annual rate of return of 10%, which is a bit high I understand, but you’ll get the idea. After seven years, Mary’s portfolio is worth almost $21,000, while Bob has nothing. Upon hearing of her accumulated wealth at a New Year’s Eve party, Bob finally gets with the program and starts to save that same $2,000 each year. At the same time, Mary decides it’s time to start enjoying herself a little more, so she no longer saves that $2,000. 40 years goes by, after which time Bob and Mary get together over drinks to compare notes on their lives. Mary’s portfolio was then worth $930,641 with only the original $14,000 invested, whereas Bob’s portfolio is worth a smaller $893,704, even though he had put in $80,000 over those 40 years!

So as you can see, thanks to the incredible power of compounding, Mary made 66x her money, while Bob only made 11x his money, simply because Mary started sooner and allowed her money to compound. That is how you build wealth.

Now I realize that it’s not possible to earn a constant 10%, or any percent for that matter, every single year. Some years you’ll make more; others years less. Yet the concept, and the math, is both powerful and irrefutable.

So what does this mean for everyday investors? The first takeaway is to start saving early; the earlier the better. The second is to reinvest your interest and dividends. Third, and related to the last point, is to invest in companies that pay dividends, and preferably, increase those payments every year. One of the greatest investors of the last 50 years, Warren Buffett, built his fortune by compounding his investments.

I have tried to incorporate the same basic strategy into the way I manage investments on behalf of my clients: I buy solid, dividend-paying stocks, reinvest the income, and continue to hold the stock for as long as the investment thesis remains intact, thereby deferring taxes, which also helps you compound your income.

This isn’t rocket science. But it does require discipline and patience. It isn’t sexy but it is the surest way to accumulate wealth. So if you haven’t already done so, get started right away.

 

The Power Of Compounding
(Assumes a 10% compounded annual growth rate)
Investor A Investor B
Age Contribution Year-End Value Age Contribution Year-End Value
21  $               –  $                    – 21  $        2,000  $             2,200
22  $               –  $                    – 22  $        2,000  $             4,620
23  $               –  $                    – 23  $        2,000  $             7,282
24  $               –  $                    – 24  $        2,000  $           10,210
25  $               –  $                    – 25  $        2,000  $           13,431
26  $               –  $                    – 26  $        2,000  $           16,974
27  $               –  $                    – 27  $        2,000  $           20,872
28  $        2,000  $             2,200 28  $               –  $           22,959
29  $        2,000  $             4,620 29  $               –  $           25,255
30  $        2,000  $             7,282 30  $               –  $           27,780
31  $        2,000  $           10,210 31  $               –  $           30,558
32  $        2,000  $           13,431 32  $               –  $           33,614
33  $        2,000  $           16,974 33  $               –  $           36,976
34  $        2,000  $           20,872 34  $               –  $           40,673
35  $        2,000  $           25,159 35  $               –  $           44,741
36  $        2,000  $           29,875 36  $               –  $           49,215
37  $        2,000  $           35,062 37  $               –  $           54,136
38  $        2,000  $           40,769 38  $               –  $           59,550
39  $        2,000  $           47,045 39  $               –  $           65,505
40  $        2,000  $           53,950 40  $               –  $           72,055
41  $        2,000  $           61,545 41  $               –  $           79,261
42  $        2,000  $           69,899 42  $               –  $           87,187
43  $        2,000  $           79,089 43  $               –  $           95,905
44  $        2,000  $           89,198 44  $               –  $        105,496
45  $        2,000  $        100,318 45  $               –  $        116,045
46  $        2,000  $        112,550 46  $               –  $        127,650
47  $        2,000  $        126,005 47  $               –  $        140,415
48  $        2,000  $        140,805 48  $               –  $        154,456
49  $        2,000  $        157,086 49  $               –  $        169,902
50  $        2,000  $        174,995 50  $               –  $        186,892
51  $        2,000  $        194,694 51  $               –  $        205,581
52  $        2,000  $        216,364 52  $               –  $        226,140
53  $        2,000  $        240,200 53  $               –  $        248,754
54  $        2,000  $        266,420 54  $               –  $        273,629
55  $        2,000  $        295,262 55  $               –  $        300,992
56  $        2,000  $        326,988 56  $               –  $        331,091
57  $        2,000  $        361,887 57  $               –  $        364,200
58  $        2,000  $        400,276 58  $               –  $        400,620
59  $        2,000  $        442,503 59  $               –  $        440,682
60  $        2,000  $        488,953 60  $               –  $        484,750
61  $        2,000  $        540,049 61  $               –  $        533,225
62  $        2,000  $        596,254 62  $               –  $        586,548
63  $        2,000  $        658,079 63  $               –  $        645,203
64  $        2,000  $        726,087 64  $               –  $        709,723
65  $        2,000  $        800,896 65  $               –  $        780,695
66  $        2,000  $        883,185 66  $               –  $        858,765
67  $        2,000  $        973,704 67  $               –  $        944,641
Less Total Invested:  $           80,000  Less Total Invested:  $           14,000
Net Earnings:  $        893,704  Net Earnings:  $        930,641
Money Growth Multiple: 11      66
Advertisements

Don’t Succumb To Blind Fear

The past week has been a very turbulent, and nerve-wracking, time for investors. Stock markets around the world have been rocked by massive losses. In just the seven trading sessions, the Dow Jones Industrial Average (#DJIA) has fallen about 850 points, or 5%. By comparison, the S&P 500 has fallen 5.2%, the UK FTSE a slightly better 4.8% while the German DAX has dropped a whopping 6.9%. These are significant losses in only seven trading days.

Today was a microcosm of the past few weeks as the major averages were whipsawed all day long. At one point, the #DJIA was down 2.8%, before finishing down 1%. Similarly, the Dow Jones Transportation Average (#DJTA) was also down 2.8% before actually ending the day 18 points higher. The S&P 500 dropped 3% before winding up down only 0.9%. Investors who panicked today and sold at the bottom will likely regret that when the market inevitably recovers and they find themselves sitting in cash on the sidelines, missing the large gains.

So what are the reasons for the big declines and the crazy volatility? They include (just to name a few): a growing economic malaise in Europe, concerns about a continued economic slowdown in China, fears on an expanding Ebola outbreak, continued trouble in the Middle East thanks to ISIS and other terrorists, plunging oil prices thanks to the dollar surging in value against most other currencies and horrible policy decisions within OPEC. You could probably add concerns over social unrest in Hong Kong. Don’t forget natural disasters like cyclones, hurricanes and typhoons that are growing in frequency and magnitude. And that doesn’t even count worries about economic slowdown in this country, anticipation about future rate increases by the Federal Reserve and uncertainty about the upcoming mid-term elections. Phew, did I miss anything?

Given all the ills that I enumerated above, we should all dump everything, build a bomb shelter and stick all of our money under our mattress, right? WRONG!! Succumbing to fear, acquiescing to panic and abandoning your financial plan is exactly the opposite of what you should be doing.

First of all, in my opinion, you shouldn’t be investing any money that needs to be spent in the next two years. So if we take that as a given, and if we assume (yes, I know what happens when we assume, but that’s the only way I can continue this narrative) that the money you have invested is for some future purpose (of at least five years), than weekly volatility is really irrelevant. In fact, it is normal and present opportunities.

Let’s put things in perspective. On October 9, 2007, almost exactly seven years ago, the #DJIA was 14,164.53. From there it proceeded to go down for the next year and a half, finally hitting bottom on March 9, 2009 at 6,547.05, for a loss of 53.8%. From that low, the market hurtled forward for the next five and a half years, erasing all of those losses before peaking on September 19 at 17,279.74, a gain of 163.9%! Today the #DJIA closed at 16,141.74, which means we’ve fallen 6.6% from the high. Is that really so bad? In the grand scheme of things is that likely to derail your future plans?

The truth about the stock market is that it goes up and it goes down. And after a prolonged period of going up, with only a few very short down periods, we were due for a correction of sorts. Now, I don’t know either the depth or duration of this correction, but I’m confident it won’t be nearly as bad as 2008/2009. Global economic conditions are MUCH better today, even with all of our problems, than they were back then. So relax, have a nice glass of wine (or whatever your drinking pleasure is), take stock of your portfolio and look at your “wish list” of stocks that you’d like to buy. Perhaps now is the tie to use some discretionary cash to pick up one or two of them on the cheap. Then sit back, wait for the rebound and congratulate yourself for remaining calm and sticking with your plan.

Full disclosure: I purchased one new position last week, and another one this afternoon, totaling about $600,000. So I’m putting my money where my mouth is. I’m very confident those will be very opportunistic and profitable purchases, creating solid profits for me and my clients for years to come.