Albert Einstein is credited with saying, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.”
In successful investing, compounding growth plays an outsized role in the outcome. Compounding in the investing world is the idea that the growth rate of a given investment account applies to both the contributions made to the account and the accrued growth in the account. For example, someone who transfers $10,000 to a high-yield savings account paying an annual interest rate of 5% will make $500 in the first year but $525 in the second year. The additional interest earned, despite the saver not adding a dollar to the account and the interest rate staying the same, is the beauty of compound interest! In an investment account holding various stocks and bonds, the same concept applies and is typically expressed as “reinvesting” the dividends and capital gains earned in the account.
Check out what some of the world’s most successful investors have to say about the power of compounding:
Warren Buffett – “My life has been a product of compound interest”
Charlie Munger – “The first rule of compounding. Never interrupt it unnecessarily.”
Morgan Housel – “It’s hard to believe that over the last 100 years, the S&P 500 rose 273-fold, but adjusted for dividends, it rose 18,520-fold.”
Howard Marks – “It’s important to understand the importance of compounding and how rare and special long-term compounders are. This is antithetical to the ‘it’s up, so sell’ mentality but, in my opinion, critical to long-term investment success.”
Compound interest isn’t just reserved for big-name investors; its power applies to anyone committed to a consistent and disciplined investment plan. To illustrate this, I want to tell you a little story about “Simple Sam” and “Compounding Charlie”. These two investors are committed to the same savings goal but will have vastly different outcomes over time.
The Starting Line: Contribution Strategy
Simple Sam and Compounding Charlie began saving $200 each month at age 18. By age 58, they both had faithfully stashed away their monthly savings and hoped to enjoy an early retirement and “work optional” lifestyle. They also chose the tried-and-true investment vehicle: the S&P 500 index fund. The plot twist? While Charlie reinvested all dividends, interest, and capital gains, Sam didn’t.
Furthermore, Sam kept his savings in a zero-interest checking account. Charlie parked his cash in a high-yield savings account, enjoying an average 4% annual return over 40 years. Both saved an emergency fund of $25,000 in their first year of savings and never added a dollar to the account again.
Let’s crunch some numbers:
- Investment Account Results
Assuming an average 7% annual return from the S&P 500 after adjusting for inflation and that 3% of the growth is attributable to dividends and 4% to market appreciation:
Simple Sam’s account after 40 years = $228,061 (https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator).
Compounding Charlie’s account after 40 years = $479,124 (https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator)
By reinvesting dividends consistently, Charlie’s account balance is more than double Sam’s!
- Savings Account
Sam’s savings sit there, looking pretty but not growing, and he has the same $25,000 in the account 40 years later. After inflation, the $25,000 is worth far less than when he started savings.
Charlie, on the other hand, has his funds working for him at 4% per annum and has turned the $25,000 into $120,026. It’s nearly five times larger than Sam’s balance! (https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator)
The Verdict
Compounding Charlie’s wealth significantly outpaces Simple Sam’s. By reinvesting dividends and parking his savings in a high-yield account, Charlie utilizes compounding interest and is in a much stronger financial position. While Sam is sitting on just over $253,061, Charlie has amassed a balance of $599,150 – more than double Sam’s. They made identical contributions over the 40 years – the only difference was how they invested and allowed compound interest to work for them.
The tale of Sam and Charlie isn’t just a math lesson; it’s a lesson in foresight, patience, and making your money work for you. Ultimately, it’s not just about how much you save but how smartly you let it grow.
Ask yourself: are you a Sam or a Charlie? It’s never too late to harness the magic of compounding!
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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