The Marvels of Compounding

This is a 2-part series on the Building Blocks of Wealth, where I discuss the concepts and mental models behind wealth creation.

In it, I will discuss:

1)        The Marvels of Compounding [this post]

2)        Four Types of Business Leverage To Build Wealth

Let’s dive into part 1…

Years ago I was having a conversation with someone about the components of wealth creation.

It was a topic I had been thinking about for quite some time.

I told him that the secrets to wealth can be boiled down into two things: Carried interest and compound interest (also referred to as exponential growth).

My answer at the time was incomplete, as I was too finance-oriented to see beyond how hedge fund managers, Fortune 500 CEOs, and business owners amassed wealth.

Carried interest is only a component of financial leverage. A couple of years ago I learned more about the four types of leverage, which is the topic of the next post.

But if there is one thing that is true and universal about wealth creation, it is this: It is obtained through compound interest.

It is the idea that consistent and steady increases in anything will yield larger returns as time goes on.

Albert Einstein said that compound interest was the 8th wonder of the world. Einstein went on to say that “He who understands it, earns it. He who doesn’t…pays it.”

If one of the modern world’s geniuses had such a high regard for a concept, we probably should have a basic understanding of how it works.

Although Einstein was a physicist, the concept of compound interest transcends physics and can be applied to wealth accumulation.

Everyone should know what compound interest is because it is a principle for good decision-making -in business and life.

The ideas around compounding can be applied to health, knowledge, and relationships.

My thinking around this subject has been shaped by Warren Buffett and Charlie Munger who have written and spoken about compounding extensively.

Compounding 101:

There is a popular story that exemplifies the significance of compounding:

A king once asked someone to name his reward for something he had done. The man asked for a “simple wish” – to have one grain of rice for one square of a chessboard, and to double the number of grains for every subsequent square in the chessboard, which totals 64 squares.

…It was only weeks later when the King realized he would not be able to fulfill his promise as this would equate to 18,446,744,073,710,149,632.

It is often hard to comprehend the effects of compounding (or exponential growth). The human mind is hardwired to think in terms of linear, not exponential, growth.

Would you believe that a penny doubled daily for 30 days grows to over $10 million?

Compounding occurs when you grow something at a given rate of return.

If you grow something at a specific rate, the amount you get back grows larger and larger in every period of time.

Even though your percentage rate of return (or growth) is the same, the nominal value of your returns grows larger in every period of time that passes.

I’ll demonstrate how this concept works in investing, even though it exists in other fields as well.

Assume you have $ 100,000 in a stock and it grows at 10%, you earn $10,000.

But now that $10,000 return will be reinvested back into the original stock, so that the new capital base is $110,000.

If the stock earns 10% again in the following year, the amount you earned in that year is now $11,000 - $1,000 more than you earned the year before.

Essentially, the return on a given initial amount (principal) earns a return, and that return is reinvested to the original capital base which earns the same return. The longer this goes on, the more wealth is accumulated.

The returns often appear small compared to the principal during the early period, but continue to grow disproportionately larger as time goes by.

In the example that was given above, you invested $100,000 at a 10% rate of return to earn $10,000 in year 1.

By year 20, you would be earning $61,159 on the initial investment of $100,000 in that year alone – a 6.1x multiple on your year 1 earnings. The total value of the investment would have grown from $100,000 to nearly $673,000.

By year 25, you’ll make the same amount you invested, $100,000, in returns alone.

By year 40 you’d have returned $411,000 during that year and would have accumulated around $4,500,000 in total.

Components of compounding equation:

There are 3 components to the compounding equation: the starting base, the growth rate, and the number of periods. Refer to appendix 1 for the mathematical expression of this equation.

1)        Starting base

When talking about financial investments, your starting base is your principal, the initial capital you use for investment.

The higher the starting base, the larger the level of wealth at the end of the investment (or compounding) period.

However, the two most important factors behind the percentage growth in wealth are the rate of return and time (the compounding period).

2)        Rate of return

The rate of return is the average percentage return you can achieve over the compounding period (time).

In business, long-term growth rates are often expressed annually and are called the Compounded Annual Growth Rate (CAGR).

The rate of return of any activity or business is a result of a few factors, some of which are outside of people's control and some of which are within.

It is important to note that in reality returns fluctuate; however, some investments achieve average returns that are sustainably higher than others during the investment horizon.

Refer to Appendix 2 for a comparison of Warren Buffett's Berkshire Hathaway performance against the S&P 500 index from 1965 to 2024.

i.               Steady-state growth.

The steady-state growth of anything is the average growth rate of that category. It can be 0% or even negative, like in the print newspaper market. The change in the quality of someone’s health beyond a certain age (like 60) is negative. The market rate of return for the largest companies in the USA, like the S&P 500 index has been at around 10% CAGR.

In business, there are two other two factors (effort and skill) that build upon the steady-state growth. If you are above average in these, the rate of return will likely be above the steady-state (market) growth rate. The opposite is also true.

ii.               Effort

Effort is the time and intensity that is applied to doing something. People need to apply much more effort when they are swimming against the currents. This includes operating within an industry in decline or starting a new business and competing with incumbents. People who apply a great deal of effort when they are swimming with the currents can do wonders.

iii.               Skill

Warren Buffett said, "The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

Skill is an important requirement to achieve above-average returns. Knowing how and where to allocate capital and time is a skill. Understanding how to minimize risk is also a skill. Strategic thinking and good execution are critical for compounding wealth at high rates of return.

3)        Time

A rule of compounding is not to interrupt it.

Warren Buffett once said that there are two rules in investing:

Buffett famously said that his favorite holding period for a stock is “forever.”

These are the statements made by someone who takes compounding seriously- and who has the track record to show that it works.

If you are consistent and apply the rules of compounding over a long period of time, you will become a top performer, even with average returns.

This rule evident when you consider the fact that gains and losses are not symmetrical: if you lose 50% of your capital you need to achieve a 100% return just to get back to where you were before the loss.

This is true in financial markets, business, and in life.

Most people, even talented people, lack discipline and consistency. They go hard for a short period of time but then stop. People who go slow but don't stop are the ones who win.

The S&P 500 is an index of the largest 500 companies in the USA. You can buy into the index and passively own a fraction of the productive capacity of America.

Between January of 1965 and June of 2024, the S&P 500 index yielded ~10.20% annually if you reinvested the dividends. The total growth of this investment is 31,223%.  

Warren Buffett is one of the most successful investors of our time, so the rate of return on his investments exceeded that of the S&P 500.

Since 1965, Warren Buffett grew Berkshire Hathaway by 19.8% annually, almost double the S&P 500’s annual growth rate. This resulted in a substantial change in the company’s share price during that period, from $19 in 1965 to over $639,000 today. The growth rate in holding Berkshire Hathaway stock is roughly 4,384,748%.

Buffett summarized his achievements in a news release in June 2024:

Compounding your way to a better life:

I believe that anyone can live an exceptional life- although I know most won’t.

Most people are too focused on achieving a specific outcome quickly. They often sacrifice things other areas of life for one thing, like money or entertainment.

The areas of critical importance to living a fulfilling life are:

·        Health, wellness, and spirituality

·        Relationships

·        Knowledge

·        Finances

These factors reinforce each other so that 1+1=3. An improvement in knowledge can also improve your relationship, finances and health.

The key is to make small adjustments in each of these areas of life and to be consistent in working on them.

It is simple, but not easy.

James Clear, author of Atomic Habits said that “habits are the compound interest of self-improvement.”

A 1% daily (or even weekly) improvement in any area of life can result in dramatic differences over time. So, it’s important for anyone to focus their efforts on the habits that have the biggest impact on the overall quality of life.

When it comes to living a healthier life, something as simple as cutting out fast food and refined sugar from a diet while exercising a few times a week, done consistently, can do wonders. It can mean the difference between being an overweight and semi-mobile diabetic or someone who enjoys running around the garden and playing with his or her grandchildren at the age of 70. 

Relationships can be improved by consistently calling, asking about, and visiting people once in a while.

Investing just $500 a month, every month, into an index fund can grow into a $1,000,000 portfolio in 31 years.

Charity and good deeds also compound; people’s actions are akin to a small pebble that falls into a body of water, whereby the initial impact creates ripples that spread out in larger concentric circles throughout time.  

In the Holy Quran, it is stated:

You can become a better human being, gain influence, and become a person of knowledge and wisdom by applying the concept of compounding to your daily life. If do anything with enough intensity and consistency, you can become a top 1% performer in that field.

One of the most effective ways to become successful is by reading more and by speaking to other knowledgeable and wise people.

Warren Buffett is a learning machine and was able to build wealth by applying his learnings effectively.

A student at Columbia Business School asked Buffett how he could become as successful as him. Buffett’s response was a masterclass summarized in a few lines:

The importance of ownership in building wealth:

When it comes to building wealth, it is important to become an owner of equity.

This is a critical component of building wealth because equity ownership in a business is equity ownership in an economic vehicle that has a life of its own. You allow your money to work for you, as opposed to working for money.

Although the stock market allows people to own relatively safe investments (collectively), there is more than one road to equity ownership.

The wealthiest people have accumulated wealth by owning real estate or private businesses. More often than not, the owners of these businesses are also their operators. People have also accumulated significant wealth by working for a relatively smaller but fast-growing company that compensates some of its employees in equity.

The question as to whether a person should own equity or not is a no-brainer: at the very least, everyone should aim to own a diversified basket of stocks that will grow over time. These investments will likely result in 6%-10% annualized returns over a long-time horizon. Younger people may find it fruitful to consider starting a business or working for a fast-growing company. [Disclaimer: This is not considered professional financial advice].

It is easier for a business to grow fast (at above-market rates) in its earlier years. However, this elevated growth rate will eventually fall because of the law of large numbers and reversion to the mean. In business, these concepts suggest that maintaining above average growth rates becomes increasingly harder as the business grows. This is also why it is advantageous to work for a smaller but fast growing business. Working for a small and fast growing business does come with its own set of risks (see rule numbers 1 and 2 of investing above).

There are natural limits to growth, and these limits exist in nature and in business. A child will grow 185%-200% by their first birthday but will only grow by 0%-3.3% by their 19th birthday. Similarly, a company can easily double its size when it’s doing $1 million in sales but will trail the market's growth rate (8%-10%) if it's doing $100 billion in sales.

A company cannot logically become larger than the market(s) it operates in. This is why achieving above average growth rates is harder when investing in the stock market but involves less risk. You will get rich if you consistently invest in a diversified group of large public stocks – but it will happen slowly. That is still really good for most people.

Before Buffett started Berkshire Hathaway, he operated an investment partnership that generated over 29% annually. As his capital base grew larger, it became increasingly difficult to maintain above average returns.

The reality is that nature and markets don’t offer you opportunities to consistently double your wealth every year.  The fable of the chess board and the King demonstrates a theoretical extreme. But you don't have to double your money every year; people tend to live long enough lives whereby modest growth can compound in their favor.

P.S. You can play around with this compound interest calculator to see the effects of exponential growth – I think you’ll find your results surprising.

https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

Appendix 1: The compound interest formula

Appendix 2: Berkshire Hathaway's performance relative to the S&P 500 index (1965-2024)