“Money makes money. And the money that money makes, makes money” – Benjamin Franklin
Compounding is repeated actions that build on each other to produce results that are dramatically larger than you might expect. Compounding is used in saving and investing to illustrate the exponential effects of earning a return on money invested over time. The effects of compounding are difficult for the human brain to grasp, but small repeated actions build on each other to produce results that are dramatically greater than we might expect, and the biggest growth comes in the later years. For example:
Suppose you started with one penny on the first day of the month and then doubled it each day—to two cents, then four, then eight and so on. After 10 days, you’d have $5.12. After 20 days, you’d have $5,242.88 and, after 30 days, you’d have more than $5 million.
But in real life the slow building effects of compounding are hard to appreciate because life is lived day by day and the exponential payoff takes decades to see.
How does the compounding effect play out in real life? Compounding effects are evident in our careers, exercise, nutrition, and wealth accumulation. Are you going to go see the surgeon who is doing his first hip replacement or the one that has done 5,000? You’re going to go to the surgeon who has done 5,000 procedures already because his knowledge of doing the procedure has compounded each time he has performed the operation. If you were to eat a cookie everyday and not change your exercise habits, what would happen over time? The extra 78 calories a day would compound to 390 a week, 1,560 a month, and 20,280 a year, and would result in 5.8 lbs. of weight gain. (Mayo Clinic)
How about the real-life example of one of the richest men in the world, Warren Buffett, who says, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” (Fortune) His wealth has compounded since he first began investing at age 11. By age 15 he had a net worth of $6,000, at age 30 he was a millionaire, and at age 56 he became a billionaire. Now at age 88, he is worth over $88 billion. Notice how it took him 26 years to go from being a millionaire to a billionaire, but in the next 30 years his net worth climbed by $87 billion, that’s due to the exponential growth of compounding.
Skeptical? Anne Scheiber was 51 years old when she retired from her job as a low-level auditor from the Internal Revenue Service in 1944. She never earned a salary of more than $4,000 per year and when she retired she had a $3,100 annual pension and a $5,000 nest egg. When she died in 1995 at the age of 101, she left a $22 million gift to Yeshiva University in New York to provide scholarships for young women. (Yeshiva University)
According to her lawyer Ben Clark, “she had left the Internal Revenue Service in 1944, investing her $5,000 savings in the stock market with the same studiousness she had applied to auditing tax returns. Over the next half century, she parlayed that $5,000 into a portfolio that included holdings in Coca-Cola, Paramount, Schering-Plough and more than a 100 other stocks that by her death last January at the age of 101 were worth about $22 million.” Her investment strategies were simple, if not old-fashioned. Forget about market highs and lows on any given day, month or year. Reinvest your dividends. Hang tough and seldom sell.” (New York Times)
Scheiber’s story demonstrates the value of sensible long-term investing. She also proves that you don’t necessarily have to have a lot of money when you start out to accumulate a small fortune through continuous compounding.(Although living to 101 helps!)
In order to get the most from the compounding effect:
The earlier you start making small changes, the more powerful the compound effect – As we like to say it’s time in the market that matters most.
Be consistent – make it a habit. When it comes to saving, pay yourself first by having money automatically deducted from your paycheck.
Be patient – Yes the compound effect takes time before you see results, but you will achieve the benefits, it’s inevitable.
Begin with the end in mind – Money creates freedom. Use it as a purposeful tool to pursue your goals in life.