The most powerful force in investing is compound interest. As Charlie Munger, Warren Buffett’s long-time partner once said “Understanding the power of compound return and the difficulty getting it is the heart and soul of understanding a lot of things.” The examples of compound interest that we see presented most often are those that show its power over long periods of time.
Here we illustrate the power of compounding in another way. The chart below shows the gain on a $10,000 investment over a 20-year period using different rates of return. The rates of return are on the horizontal axis with each corresponding dollar gain on the vertical axis. Note that starting at 1%, each successive return is double the prior return.
Here’s where compound interest shows its power. As each rate of return doubles, your profit more than doubles. When you compound at 2% for twenty years, your profit is 2.2X your profit when compounding at 1%. And when you compound at 8% for twenty years, you have more than 3X the profit that you do when you compound at 4%. Double your return again, which is admittedly unrealistic over a 20-year period, and your profit is 5X your profit when compounding for 20 years at 8%.
You can read more about the awesome power of compounding in a neat little story Dick Young tells readers here.
Jeremy Jones, CFA
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