The Power of Compounding

| February 15, 2006

Warren Buffett, Richard Russell and we (among others) know a little secret, and after reading this article you will too. Further, instead of making you wait until the dramatic conclusion of this piece, I’m going to just go ahead and blurt it out right here at the outset:

Compounding is the only guaranteed way to create real wealth.*

Yes, you heard me right. If you faithfully follow the compounding program, you are guaranteed to build a fortune! Of course, there are a couple of rather critical caveats (you did notice the asterisk above, right?), but we’ll get to those in a bit…

What is Compounding?

Compounding is a slow, boring process by which wealth is created over mind-numbingly long periods of time. Excited yet? Webster’s Dictionary defines financial compounding as: “The process of computing interest on the principal and accrued interest.” In other words, every time you calculate earned interest on a given investment, you base that calculation on both the original principal and any accrued interest that has been reinvested. So compounding is the process by which you earn interest on both principal and reinvested interest. Pretty basic, right? Well, although the process itself is simple enough, the power of it is lost on most people. Let’s look at an example that graphically displays its wealth-building power…

The Billionaire, The Boy and The Broom

There once was an eccentric billionaire who hired a neighborhood boy to sweep off his front porch every day for a month. Before the first day of work, the billionaire gave the boy a choice of salaries: he could either earn $1,000 per day for the entire month, or start at a salary $0.01 per day on day one, and then have his salary double every day of the month. Of course, the young boy jumped at the chance to earn the $1,000, and when he was done, he happily walked away with $30,000 dollars, but let’s crunch the numbers and see how those two deals really compared…

Option #1: 30 days at $1,000 per day
Total salary: $30,000

Option #2: Salary starts at $0.01 on day #1 and doubles every day thereafter

Daily Salaries

  • Day #1: $0.01
  • Day #2: $0.02
  • Day #3: $0.04
  • Day #4: $0.08
  • Day #5: $0.16
  • Day #6: $0.32
  • Day #7: $0.64
  • Day #8: $1.28
  • Day #9: $2.56
  • Day #10: $5.12

So after 10 days he’d only be making a little over $5 per day. So far, option #1 is still looking pretty good, right? Let’s go another ten days…

  • Day #11: $10.24
  • Day #12: $20.48
  • Day #13: $40.96
  • Day #14: $81.92
  • Day #15: $163.84
  • Day #16: $327.68
  • Day #17: $655.36
  • Day #18: $1,310.72
  • Day #19: $2,621.44
  • Day #20: $5,242.88

Now we’re talking about real money here. By day #20, the boy would have been making over five times per day what he did with option #1. Plus, we still have 10 more days to go!

  • Day #21: $10,485.76
  • Day #22: $20,971.52
  • Day #23: $41,943.04
  • Day #24: $83,886.08
  • Day #25: $167,772.16
  • Day #26: $335,544.32
  • Day #27: $671,088.64
  • Day #28: $1,342,177.28
  • Day #29: $2,684,354.56
  • Day #30: $5,368,709.12

No, that’s not a typo. By day #30, the boy would have made over $5 million per day if he had chosen option #2!

Total Salary: $10,737,418.23

Option #2 would have earned the boy over $10 million dollars in one month, starting at only $0.01 on the first day. That’s the power of compounding! Of course, the example is exaggerated, as the boy would have essentially earned interest of 100% per day, compounded daily, with option #2, but the story is an effective way to get the point across in vivid fashion.

Patience and Discipline

Another characteristic of the compounding strategy that the preceding example illuminates is the fact that it takes long periods of time to work its magic. After 10 days, or one third of the entire month, option #2 was still only paying about $5 per day. However, after another 10 days the salary had jumped to over $5,000, and then finally to over $5 million. Again, compounding is slow. It takes time. And this is precisely why so few people are equipped to take advantage of its benefits.

In order to reap the rewards of compounding, the investor is forced to be both patient and disciplined. Patience is obviously required, because the investor must sit and wait for the compounding process to work, but discipline is also necessary in that accrued interest must continually be reinvested for the process to get underway in the first place. Consider the story again. What would have happened if option #2 also provided the ability for the boy to receive tomorrow’s raise today in the form of a dividend, instead of going into a salary increase? In the extreme case, the boy would opt to receive his dividend pay-out every day, and his daily salary would never increase from $0.01, providing him total earnings of under $1 for the entire month! Without reinvestment, the compounding process can never even get started.

Compounding and Investing

We believe that compounding should be the foundation of every investment portfolio. That means buying Treasures, municipal bonds, preferred stocks, high-quality stocks yielding regular dividends, and high-quality growth stocks that are judged to reinvest their earnings in an optimal manner, and then reinvesting all paid dividends. It also means having the patience and discipline to faithfully follow the compounding strategy, as well as being cognizant of and aligned with the primary trend of the stock market.

Unfortunately, most investors are far too impatient and undisciplined to make use of this powerful process, instead opting for high-stakes, high-risk strategies such as day trading and speculation. However, we believe that anyone can overcome these impediments of human nature and become a successful compounder through education and understanding. What about you? Would you rather invest in a boring guarantee or a high-risk roll of the dice? As for us, we’ll take the boring guarantee every time.

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