Compound interest is the eighth wonder of the world. He who understands it, earns it …he who doesn’t…pays it – Albert Einstein
What is it?
Compound interest or returns is essentially growth on top of growth as time passes. Another way to think of it is to use a snowball metaphor. When you first start rolling a snowball down a hill it is small and what it can accumulate is relatively small. However, as any kid can attest to, slowly over time, the snowball accumulates more and more, as the snowball gets bigger its ability to accumulate more snow grows. Eventually, given enough distance, the gains compared to what were gained at the start of the hill are hugely different. More succinctly, compounding is the process of generating earnings on an asset’s reinvested earnings.
The concept of compounding is integral to good financial planning. It can be applied on many levels. On the surface, it begins with starting by saving/investing early so that gains can be compounded over a long period. The next level is to understand how it can work against you. For example, paying the minimum amount on a credit card bill snowballs against you. Another level is to consider expense fees, taxes and other costs related to your investments and how that 1 or 2% difference (say comparing actively managed mutual funds vs index funds) adds up over time. And on yet another level, it can play a factor in decision making. For example, what would the true cost over time be of deciding between a $30,000 car and a $40,000 car if you were to invest the difference?
Thoughts from other Investors
“The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling” Seth Klarman
“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things” Charlie Munger
“The tyranny of negative compounding returns maybe the hardest lesson that far too many investors never master” David Rolfe
“Compounding matters and does so far more than people expect. The human brain thinks in a linear way which means that if we were asked to estimate what 10.22% compounded over 100 years would be then our answer is likely to be closer to 1,022% than 1,679,600%, something economists call exponential growth bias. This means that compounding is often underestimated and should be at the heart of long-term investing” Marathon Asset Management
Tyranny of Fees – LINK