The two most important words in investing are “compound interest.” Albert Einstein referred to compound interest as the eighth wonder of the world. And Ben Franklin said compound interest is “the stone that will turn all your lead into gold.”
Many investors are familiar with compound interest, but few appreciate its awesome power. Until you fully appreciate the power of compounding, attempts at crafting a successful long-term investment strategy will likely fall short. If you are among the millions of Americans who still believe investing is buying a security today and selling it at a higher price tomorrow, the power of compounding has not yet sunk in.
Here’s some compelling compound interest arithmetic for you to consider. Let’s say you invest $10,000 at 10% for 20 years and draw your interest out each year to spend at Whole Foods or your local Harley dealer. At the end of 20 years, you will still have your $10,000 principal plus the value of $20,000 in interest drawn over the period—a total economic value to you of $30,000. Now let’s assume that you instead made no draws and reinvested at 10% for 20 years. Your economic value at the end of 20 years would be $67,274. That’s $10,000 original principal, $20,000 in simple interest, and $37,274 in interest on interest (to total $67,274). Wow! Over half of your total economic value comes from interest on interest. Over long periods, interest on interest can account for over 60% of your returns. That is power! That’s investing.
If you invest for a compounded rate of return of 10%, it’s easy to think that your long-term return would be twice the return gained by investing at 5%. That is not the case—not by a long shot. Let’s take a long-term look here. Investing $10,000 at 5% for 40 years gives you $70,000—a respectable sum, to be sure. But at 10%, $10,000 grows to a staggering $452,000. You end up with not double the money, but almost 6.5 times the money you would have earned at a 5% return. Double the growth rate again to 20% (admittedly unrealistic, but useful here), your $10,000 would become a mind-boggling $1.47 million (over 21 times the return). And you thought you understood compound interest?
When you invest in portfolio securities, your first question should be: What am I getting paid? If you want to harness the power of compound interest, avoid securities that pay you neither interest nor dividends. Do not put your hard-earned capital at risk with the view of buying a portfolio security today and selling it to someone else tomorrow at a higher price. To me, this is called speculation, not investing.