What do all wealthy people have in common? What is it that allows them to accumulate much more money that most other people? Simply, it is the principle of compounding.
Just thinking about the fact that billionaires exist is often mind-boggling to me. The average net worth per adult worldwide, according to a recent Credit Suisse report, is around $77,309. That number, of course, is skewed upward because of the ultra-wealthy (mean vs. median). Looking at the median net worth of American families, the number is $52,700, based on 2016 data from the Survey of Consumer Finance.
Though $52,700 is a lot of money by many people’s standards, that is a far cry from a billion. A billion is:
That’s nine zeroes! No one ever reaches that level or wealth or even much lower levels of wealth through their hard word alone. It is their money that has to work for them.
In the ancient world, there were a few great monuments that were considered to be the greatest structures ever created. These included the Hanging Gardens of Babylon, The Lighthouse at Alexandria, and others. These were huge man-made structures that invoked a sense of awe and wonder in the people who were around to behold them. The only surviving one of these structures is the Great Pyramid at Giza, in Egypt.
The concept of compound interest is what legendary scientist Albert Einstein called “the 8th wonder” of the world. He believed that, because of its mathematical power, it was right up there in influence with the great monuments of the ancient world.
In fact, he is often quoted as saying, “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t, pays it.” Let’s understand why this force can be so powerful in our lives.
The concept of interest has been around as long as the original 7 wonders have - there are records of clay tablets recording annual growth rates of loans. In fact, Roman emperor Cicero once remarked in writing to a friend that he would not charge someone more than 12% annual interest.
Compound interest is when money grows into more money. It is one of the principles around which the entire financial system exists.
Let’s say I lend you $100, and you agree to pay me back 10% interest in one year’s time, plus the original $100 that you owe me. This means you’d pay me back $110, and I’d have made a profit of $10. This is the concept of simple interest.
But let’s say you need more money and want me to lend you some more. I lend you the $110 and charge the same 10%. After another year, you’d owe me $11 in interest, which makes the total $121. Notice that the amount of interest went up by $1 after another year. This is the power of compound interest. Money earns some money, and then that money earns even more.
When you pay interest to someone, you are renting their money. When you collect interest, it is because you are renting it out to someone else.
Remember in Part I where I mentioned that time is our most precious resource? Well, time and money have an interesting relationship with each other. If you were to lend me money for a year, how much interest would you charge me? Maybe 5%? Maybe 10%? What about if we agreed to a loan term of a much longer period of time - say 10 years. How much interest would you charge me then? Surely it would be more, maybe 15% or 20%.
What’s the reason? It is because by taking longer to pay the loan back, you have to wait and can’t spend that money yourself. In order to compensate you for the time I am taking to pay it back, you’d demand a higher rate of interest. This is the concept of the time value of money.
You want to build wealth. You want financial freedom. This is the fundamental principle of how you do it. It is the most important concept to understand. Everything relies on the principle of compound returns.
When it comes to compounding money there are three things that matter:
The more money you put aside to invest, the more you will have in the long run. One of my best investments percentage-wise doubled within one year. It hasn’t made me much money in
absolute dollars though, because I didn’t put that much money into it. I didn’t have a lot to invest at the time but I still saw the opportunity and wanted to take advantage of it with what I had.
Contrast that example with other investments I’ve made that have grown more modestly, but resulted in a greater increase in value. It’s because I was more committed to the investment and put more money into it in the first place.
Every dollar counts, but more dollars invested makes more of a difference. Here’s the difference between investing $100 and $1,000.
If you put in ten times the money, you get ten times the results. The relationship between what you get is proportional to what you put in.
Time is another factor in compounding, and boy is it a huge one. When money grows, it starts doing so slowly. It feels like it’s moving up linearly, but it’s not. It actually grows exponentially, and this is where the magic comes in.
If you invest $100 and wait 1 year (assuming you earn 10% annually on your investment), you’ll have $110. If you wait 5 years, you’ll have $177. If you wait 10, you’ll have $259.
What if you wait 50 years?
$100 invested for a 50 year period would net you a total of $11,739.
To put this into perspective, $11,739 is over 45 times as much money as if you had waited only 10 years. Yet, you only waited 5 times longer. Because of how time influences compounding returns, you get disproportionately more than what you put in.
One aspect we need to consider when it comes to time is that we have no control over it. It just happens. The only thing we can do related to time is making sure that we stay invested, and don’t cash in our investment prematurely. Compounding is powerful, but it needs time to do its work.
The third and final factor that influences how much money compounds is rate of return. The rate of return on an investment is influenced by many factors, and we’ll discuss what those are soon. For now, just know that the higher the rate of return, the faster money compounds. A 1% or 2% annualized rate of growth in our investments won’t do much for us - especially considering that prices on goods and services generally go up around 3% or 4% per year (this is called inflation).
At 5% or 6% we’re doing a little bit better - in this range we’re modestly growing our actual purchasing power over time. Years from now, we’ll be able to buy more goods and services than we can today, even adjusting for price increases.
Once we get north of 10% rates of return, real wealth can be created over time. In fact, 10% is the historical average of stock market returns over the past century or so. Many individual stocks perform worse, but many perform much better as well, with some stock investments returning 15%, 20%, or 30% annually to their investors.
Above this, it is possible to earn 50%, 800%, or 1000% returns on your money. This is what happens when you start a business and grow it over time successfully. It is the realm of the entrepreneur, and theoretically, there is no limit to the level of growth that is recognized here.
Some people would say that those kinds of returns are crazy and that we can never expect those returns. Well, that may be true, if you never plan on running a business yourself or learning an advanced investing skillset.
What we’re interested in is how well we can do purely from the perspective of an investor. That means we don’t have to actually run a business ourselves, but rather, we can pay someone else to run it for us (either privately or in the form of stock ownership). Our wealth grows not because we exchange our time for it, but because we exchange our money for it. In fact, the act of being an investor is to purchase more money in the future.
When we want to get wealthier, we just buy more money.
Here’s how rate of return influences our compounding results. $100 invested at a 1% rate of return (assuming you hold the investment for 10 years) is $110. If you earn a 10% rate of return instead, you would have $259. With a 15% rate of return, you would have $404.
We now understand the three components that make the eighth wonder of the world - compounding - build wealth for us. We understand that money has a time value related to it, and that in order to really build wealth, we need to earn more than inflation.
The art and science of investing is about putting these pieces together for our benefit. We can construct a plan to attain a certain level of wealth, depending on how we want to make these three variables work for us.
Let’s say you want to build a portfolio of $1,000,000. If you had no debt, this would make you a millionaire, and by many people’s standard of living, would make you financially free. Here are a few examples of how to achieve this given what we now know.
Example 1: Invest $100 per month, at a rate of 15% annually, for 33 years.
Example 2: Invest $500 per month, at a rate of 5% annually, for 45 years.
Example 3: Invest $1,000 per month, at a rate of 10% annually, for 23 years.
As you can see, there are many ways to achieve the same goal, and these are just three examples. The right combination for you will be determined by your personal circumstances, your lifespan, ambition, and other factors. Figuring out what works for you is personal, and only you can decide what works best for your money.
If you’ve made it here though, you’re interested in learning how to optimize that third variable - Rate of Return. Amount and Time are the two factors of compounding that are most easily understood, but what about Rate of Return? How do we find investments that return 5%, 10%, 15%+?
The answer is in buying assets, which we’ll cover in Part III.