Lacking financial literacy, many people are unaware of what might be the most important factor for increasing your own capital. It’s a term that Albert Einstein referred to as “the greatest mathematical discovery of all time” (and Albert Einstein knew something about math) and “the eighth wonder of the world.” If there is anything you need to know about finance, it’s Compound Interest (Compounding).
But compounding is not just math or finance. It’s a more profound idea than it may seem at first. Warren Buffet’s partner, Charlie Munger, once said that “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.” So, what really is compound interest?
Compounding is the process where the value of an investment increases exponentially. This growth happens as the interest rate that applied only for the principal in the first period applies for both principal and interest accumulated in the second period. For instance, if your average return is 10%, then $100 would become $110 after a year ($10 earned), but in the second year you would get $11 and then $12.1 in the third year and $13.3 in the fourth year. After nine years, you would earn more than $20 per year, which is more than twice what you made the first year! The cause of this phenomenon is that essentially you would earn interest on the interest that was earned before.
The average person easily understands the idea, but not many apply it to their behavior in the market. Why?
Most people have linear thinking
Humans have evolved over millions of years in a very linear environment. The amount of time you would invest in growing crops or hunting correlated to the amount of food you produced. In former times, technology evolved very slowly, and most people died in the same area they lived in and did everything practically the same way all their life.
If a lion was running toward you, you just needed to run away quickly. If you wanted to buy something, you needed to provide something in return. Everything was quite simple.
Today, the world is very different. The amount of data multiplies every few years. Technology changes dramatically, industries are being disrupted on a daily basis, and no one knows how his career will look like ten years from now. Yet, genetically, people have not changed much. Our brain is the same brain as that of a Homo sapiens who lived a few thousand years above and was trying to hunt for his food. A few thousand years is nothing in the perspective of evolutionary change.
Thus, people are still thinking mostly in a linear way, while many fields are acting exponentially. A researcher can sit for a few years in a lab and then suddenly have a breakthrough out of the blue. His progress was not linear, as he didn’t come close to the target each day by equal steps.
The stock market is also not acting in a linear way. For instance, the 10 best and worst days every year are responsible for most of the return that year, and the best proof for linear thinking is that most people ignore compounding. How do I know that?
- Most people treat their savings the same at every age. They try to save the same amount of money each year. Even worse, governments force people to provision monthly for pension plans, but the percentage is the same for someone 20 years old as it is for someone 60 years old. It’s even worse than that since a person’s salary mostly increases as you become older, and therefore the amount you provision for your pension is actually greater in real value in older ages, when you won’t be able to enjoy compounding for many years like young people can.
- Most people are not saving much while they are young. They intend to save later, but doing this means that you would need to save much more money later to equal the sum you would have had if you had started saving in your 20s.
- The result is that people are not aware that each dollar today is worth much more than a dollar will be the future. Limiting spending, saving more money, and investing this money can allow you to spend more money later in life.
Thus, if you tell someone in his 20s that he can gain a 10% annual return for 40 years, he might do the math in his head: 10%*40 = nice, 400%. In real life, his return after 40 years would be more than 4,500%! And this gap in returns increases as the period of time increases.
So what can we do?
The three holy words are saving, investing, and compounding. Every dollar you save counts, and be sure this dollar is invested and earns interest. It should also be noted that to enjoy compounding in full you need to reinvest any payments you get in the form of coupons, dividends, and rent.
Every dollar matters, especially when you are young, and this is also one of the fundamentals of investment models aimed at young people. Most portfolios built for young people come with higher risk in anticipation of gaining a higher return. Portfolios of older people usually offer less risk, as these people will probably need the money sooner, and the anticipated return is not worth the risk. I can’t advise you to be young, but I can definitely advise you to enjoy the pure joy of compounding. Trust Einstein.