Einstein calls compound interest the eighth wonder of the world. He said, “he who understands it, earns it; he who doesn’t, pays it.“
Compounding is the magical result of small actions performed consistently over a long period of time. This concept can be applied in any field namely investing, health and fitness, relationships, learning, growth, etc.
Let’s dive into how compounding can be applied to building wealth.
In simple terms, compounding refers to earning interest on interest. Let’s say you invest $100 in the stock market and it earns 10% per year. Here’s how your money grows:
- After year 1, you will have: $100 + (10% of $100) = $100 + $10 = $110.
- After year 2, you will have: $110 + (10% of $110) = $110 + $11 = $121.
- After year 3, you will have $121 + (10% of $121) = $121 + $12 = $133.
.
.
and so on.
You might think that this isn’t a lot, but keep reading to know the magic of compounding.
Scenario-1:
There is one famous example of compounding in the area of investing. Two people, Person A and Person B, start to invest money in the stock market. Let’s say both people earn a return of 10% per year.
Person A starts investing $10,000/year from age 25 and stops investing at age 35.
Person B is too busy to worry about money in his early years. He realizes a little late that he needs to save for his retirement and kids’ education. He starts investing money at the age of 35.
Person B invests the same $10,000/year as Person A but from age 35 and continually invests until age 65.
In this scenario, Person A has invested a total of $100,000 from age 25 to 35 ($10,000/year x 10 years) whereas Person B has invested a total of $300,000 from age 35 to 65 ($10,000/year x 30 years).
Who do you think will have more money at age 65?
If you guessed person B, then you are wrong (I guessed it wrong when I first came across this example). Person A will have way more money than Person B. In fact, Person A will have approximately 65% more money than Person B.
At age 65, Person A will have ~$3.3 million whereas Person B will have ~$2 million even though A invested way less money than B.
How can this be possible? Person B invested three times more money than Person A – $300,000 vs $100,000 – but he is way behind by $1.3 million.
That’s the power of compounding. Money grows exponentially when you give it enough time.
“Money makes money. And the money that makes money makes more money.”
— Benjamin Franklin
Can’t believe it? Let’s see the numbers:
| Scenario-1 | Person A | Person B |
|---|---|---|
| Starts investing at age | 25 | 35 |
| Invests $10,000 every year for... | 10 years (age 25 to 35) | 30 years (age 35 to 65) |
| With 10% return, at age 65, each person has... | $ 3,364,992 | $1,990,378 |
| Amount each person contributed | $100,000 | $300,000 |
| % of contribution to the final portfolio | 3% | 15% |
Here’s how scenario-1 looks graphically:
Now, if you look at how much each person contributed to the total portfolio, it can blow your mind as well. The percentage of contribution is the total money in percentage that each person contributed to the total portfolio at age 65.
Person A’s contribution is 3% of the total portfolio which means 97% of his wealth came from just compounding. Let that sink in for a moment. With just a $100,000 contribution, Person A has built a $3.3 million portfolio. Isn’t that amazing?
What’s more amazing is – to gain 97% in compounding – you need to make that 3% contribution. Otherwise, you will end up with nothing.
If you don’t save, you can’t invest. If there is no investment, there is no portfolio. Simple but not easy!
Let’s look at one more scenario. This time it can definitely blow your mind.
Scenario-2:
What if person A continues to invest from age 25 till 65 instead of stopping at 35?
In this case, person A has invested $10,000 per year for a total of $400,000 for 40 years from age 25 to 65. Person B has invested $10,000 per year for a total of $300,000 for 30 years from age 35 to 65.
Can you guess how much Person A will end up with at the age of 65?
.
.
.
.
.
.
$5.3 million.
Yes, it’s $5.3 million for A vs $2 million for B.
| Scenario-2 | Person A | Person B |
|---|---|---|
| Starts investing at age | 25 | 35 |
| Invests $10,000 every year for... | 40 years (age 25 to 65) | 30 years (age 35 to 65) |
| With 10% return, at age 65, each person has... | $ 5,355,370 | $1,990,378 |
| Amount each person contributed | $400,000 | $300,000 |
| % of contribution to the final portfolio | 7% | 15% |
It will be very hard for Person B to catch up with Person A. That’s the power of starting early!
“A year from now you may wish you had started today.”
— Karen Lamb
Here’s how scenario-2 looks graphically:
The two important things about compounding are to (1) start early and (2) be consistent. It’s important to start early but it is also equally important to stay consistent.
“The first rule of compounding: Never interrupt it unnecessarily.”
— Charlie Munger
Takeway
If you’re thinking about when to start investing – now is the right time. Even if it is small amounts, just start. Time is the most powerful force in investing. As seen from the above scenarios, you can see how small contributions can lead to significant wealth. Compounding is magical and an absolute game-changer.
You can’t become wealthy without saving and investing. The single most important thing you can do to become wealthy is to start investing early. The biggest resource you have is ‘time’. Make use of it!