THE POWER OF COMPOUNDING
Warren Buffett is often recognised as the world’s best investor. His net worth (despite having given large parts of it away to charity) is estimated to be in excess of $140bn. Yet more than 99% of his wealth was generated after the age of 50. Warren Buffett is now 93 years old – the secret of his success is time. While he is undoubtedly a good investor, however had he retired at the age of 65 nobody would have heard of him. In this month’s Financial View we look at why time in the market is so critical.
Einstein famously wrote about compound interest that, “Compound interest is the eighth wonder of the world. Those who understand it earn it. Those who don’t pay it.” At Magwitch we believe compounding is very important and the biggest tool at the disposal of any investor.
We often use an example of three separate investors to demonstrate the power of compounding. All will retire in 40 years’ time. The first (Alpha) will start putting R500 away a month from the first month when he starts working at age 25. The second (Bravo) will start putting R500 away a month after 10 years and the last (Charlie) will start putting R500 away a month after 20 years. All will receive 13% per annum return on their investments and will not make any withdrawals until the end of the 40 years. The accumulated growth will look as follows.
Alpha invested R240 000 over the term of the investment but had a value of R8.2m after 40 years. That would mean that almost R8m of the final investment value came from returns and the compounding thereof. Bravo invested just R60 000 less and yet had an outcome that was just short of R6m worse. Time is definitely your friend when investing.
The reason compounding is so powerful is take Alpha’s investment balance after 10 years when Bravo starts investing. Both investors invest R6 000 in the eleventh year (R500 a month) yet at that point Alpha’s balance is already R123 340. At an investment return of 13% Alpha gets a return of R16 034 in the eleventh year on their opening balance, by far dwarfing the R 6 000 that they each contribute to the investment in year 11. Similarly, when Charlie starts after 20 years Alpha’s balance has now grown to R572 760. The return at 13% would be R74 459, once again really outweighing the R6 000 that all of Alpha, Bravo and Charlie contributed in the 21st year.
All the investments grew but the longer the period of contribution, the more growth was a factor. As we said time is your most critical factor in investing.
To take it a step further, compounding allows you to double, treble or quadruple the value of your investment. There is the rule of 72 which allows you to easily calculate how long it will take you to double your money.
Rule 72: 72 /(annual return) = no of years to double your money.
Return 2% 72/2 = 36 years to double your money
Return 6% 72/6 = 12 years to double your money
Return 12% 72/ 12 = 6 years to double your money
Now back to our example: Alpha has a return of 13% p.a.
Return 13 % 72/13 = 5.54 year to double your money
It will take Alpha 5 and a half years to double his money, so if he doesn’t touch his capital and achieves the same return of 13% after the age of 65.
By the age of 70.5 years his capital will be R 16 354 338
By the age of 76 years his capital will double to R 32 708 676
By the age of 81.5 years his capital will double to R 65 417 352
And so on….
So, lets return to Warren Buffett. There is no doubt that he is an incredible individual and really one of a kind. He started earning money at a very early age having been inspired by the book – One Thousand Ways to Make $1000. Through hard work and early successes, he became a Dollar Millionaire at the age of 30, which is a remarkable achievement. At the age of 60 he grown that to about $4bn and now in his 90’s there is no sign of slowing down.
What lessons can we learn from Warren Buffett’s approach to compounding?
Here are some key lessons from Buffett’s approach:
Start Early: Buffett began investing at a young age, allowing his investments to compound over decades. The earlier you start, the more time your money has to grow.
Reinvest Earnings: Buffett consistently reinvests the earnings from his investments. By doing so, he maximizes the compounding effect.
Patience is Key: Buffett is known for his long-term investment horizon. He buys quality companies and holds onto them, allowing the power of compounding to work its magic over time.
Avoid Unnecessary Risks: Buffett avoids speculative investments and focuses on businesses he understands. This reduces the risk of significant losses that could disrupt the compounding process.
Invest in the correct asset class: You want to ensure that you achieve the highest risk appropriate return over a long period, cash at 2 % will not get you there, you will need an investment returning approximately double digit return over the long run, this means a healthy exposure to both local and global equities.
Don’t Stop: If possible, keep the investment going for as long as you can, contribute every month, do it consistently over a long period of time and don’t withdraw when you change jobs. It is what you don’t spend that makes you truly wealthy.
At Magwitch we are very passionate about investing. We get very excited when we see young clients (or parents investing on behalf of their children) as it allows for the best investment outcome and real wealth when investors stick to the plan. The earlier you start the easier it becomes to achieve your goals.
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