INTRODUCTION
“Compounding” is one of the most important concepts when it comes to investing or personal finance, and it is accessible to everyone. Compounding is your money generating more money through dividends, interest, etc., which is re-invested to earn more money or earnings; this leads to exponential growth over time. Albert Einstein hailed “Compounding as the Eighth Wonder of the world. He who understands it earns it; he who doesn’t pays it.” In the post, we’ll explore the world of compounding and its intricacies: how it works and how you can leverage the magic of compounding to increase your net worth by making your money work for you while you sleep!
ESSENCE OF COMPOUNDING
At its core, compounding is the process of generating earnings on both the initial principal and the accumulated interest of an investment. As your investment grows, so does the amount of interest it earns, leading to exponential growth over time. Compounding helps increase your earnings substantially compared to simple interest, where you get a return on your principal without reinvestment.
Compound Interest can act as your friend or foe. Compounding can be your friend regarding savings and investing, as it multiplies your investments over time. With debt vehicles like credit cards and mortgage loans, compounding acts like your foe, accruing your principal with interest not paid on time, making it increasingly difficult to pay off as time goes by.
EXAMPLE OF COMPOUNDING
Consider a person who wants to invest an initial principal amount of $10,000. Let’s see 2 scenarios where they earn 5% interest on their investment. The attached graphs show the growth difference between simple and compound interest.
If the investment earns 5% simple interest (no re-investment with 5% return every year on the principal), the total nest egg after 20 years amounts to $20,000 (Principal – $10,000 with interest of $10,000).
When compound interest comes into play, the nest egg increases to $27,126 (Principal – $10000 with interest of $17,126) over 20 years.
Source: https://banzai.org/wellness/resources/simple-vs-compound-interest-calculator
If the timeline is increased to 40 years, the nest egg with simple interest would be $30,000 (Principal – $10000, Simple Interest – 40 years * $500 – $20000)
With compounding, it would be $73,584 (Principal – $10000, compound interest – $63,584)
This is the magic of Compounding with the secret ingredient – The power of Time!
Source: https://banzai.org/wellness/resources/simple-vs-compound-interest-calculator
POWER OF TIME: THE SECRET INGREDIENT
Time is the primary secret ingredient to harness the magic of compounding. The longer the timeline for your money to compound, the more significant the impact! This is why it’s suggested that you invest early and often. Even small contributions would snowball your investment returns over time with compounding.
COMPOUNDING AT PLAY IN WARREN BUFFETT’S NET WORTH
Warren Buffet is a live example of the Magic of Compounding. According to Forbes, Warren Buffett’s net worth in March 2024 was $132.1 billion. He is currently the 6th richest person in the world.
Fun fact: Warren Buffett didn’t even become a billionaire until he was 50. 99% of Warren Buffett’s net worth was earned after his 50th birthday.
Net worth by age:
Age 21: shy of $20,000
Age 26: $140,000
Age 30: $1 Million
Age 35: $26 Million
Age 47: $67 Million
Age 56: $1 Billion
Age 60: $3.8 Billion
Age 66: $16.5 Billion
Age 72: $35.7 Billion
Age 83: $58.5 Billion
Age 92: $109 Billion
Age 93: $132.1 Billion
Source: https://finmasters.com/warren-buffett-net-worth/#gref
This shows the power of Compounding with time and consistency.
STRATEGIES FOR HARNESSING COMPOUNDING
- Invest Early and Consistently: This can be counted as the golden rule of compounding. The sooner you begin investing, the more time your money will have to grow. Regardless of market fluctuations, consistently investing a portion of your income will accumulate wealth over time.
- Choose the right investments: Look for options with higher rates of return over the long term. Stocks have a proven record of higher returns than bonds, savings accounts, or real estate. Consider diversifying your portfolio to navigate market volatility to increase your rate of return.
- Take advantage of tax-advantaged accounts like 401K, IRA, and HSAs. There are tax-advantaged accounts like 401Ks and HSAs, which include employer contributions in addition to your investment. Take advantage of free money and increase your rate of return.
- Minimize fees and expenses: Be wary of fees and costs regarding investments. Most mutual funds charge 2 or 3% in fees every year. It might not look much on the surface, but it can eat up to 1/3rd or 1/4th of your total return in the long term. Try to stick with ETFs or Index Funds with low expense ratios.
- Reinvest your Dividends and Interest – DRIPs. Most brokerages now offer Dividend Re-Investment Plans (DRIPs) to re-invest the dividends you get from your investments. Don’t miss out on this.
- Stay the course. Don’t tinker with your investments during short-term market fluctuations. Think of the long-term growth and stay the course.
- Be patient and give yourself time. Time is your ally when it comes to compounding. The longer the time frame, the greater the return.
- Avoid/reduce bad debt that compounds like credit card debt, mortgage debt, student loans, etc. Debt that compounds, like credit card debt, student loans, mortgages, etc., should be paid off immediately. Be aggressive in reducing such lousy debts.
- Check the rate of compounding. Be it investment or debt, check the compounding rate to understand what you’re earning or what you’ll owe in the long term.
CONCLUSION
In conclusion, compounding, when leveraged in the right way, has the power to transform your financial future by creating wealth and achieving your long-term goals. Compounding can help you turn dreams into reality in your journey, whether it is paying off your bad debt, saving for a down payment or your retirement, funding your child’s education, etc.
The key ingredients for Compounding are time, consistency, and patience. Start investing early and consistently, and resist the temptation to interrupt the growth of your investments during short-term market fluctuations.
Take advantage of this powerful “Compounding force” and watch your wealth grow exponentially.
