The Effect Of Compounding

Albert Einstein is reported to have described compounding as “the eighth wonder of the world.” The power of compounding is real, but it is not intuitively obvious. For investors, it makes a significant difference to one’s net worth.

A Chinese Legend

According to legend, a wily craftsman tricked the emperor of China into promising an impossibly large payment for a chessboard he had made for him. The craftsman requested the emperor to place one grain of rice on the first square of the chessboard, then double the number of grains for every subsequent square until all 64 had been filled.

By the end of the first row, the total number of grains were only 255. By the end of the second row, the number had grown to 65,535. By the 41st square, the number was over a trillion. According to legend, the king turned the tables by insisting that the craftsman count the grains to ensure the payment was correct, thus making payment impossible (as it would take nearly 300 billion years to count the grains).

The legend reveals two important lessons for investors. The first is that the effect of compounding can be astonishing. The second is that the human brain often underestimates its effects.

The effect of compounding

The chessboard example showed the effect of repeated doubling (100% return). Let’s look at the effect of a more realistic 7% annual return.

A person at the age of 20 who invests $50,000 at an average annual return of 7% would have $1,050,123 by the age of 65. But what happens if the investment is delayed by 10 or 20 years?

The table below shows that reducing the investment period by 10 years almost halves the final value of the investment, although the period has decreased by far less half (from 45 years to 35 years).

The effects of compounding appear slow at first but accelerate over time. The investors who begin later—at age 30 and 40—miss the rapid growth in the final 10 years enjoyed by the investor who begins at age 20. This rapid acceleration is often discounted by investors as it happens further into the future.

Countering your intuitions

Warren Buffet is among the world’s most successful investors with a net worth of over $100 billion. 97% of Warren Buffet’s wealth was accumulated after the age of 65.

The good news is that anyone can access the power of compounding by starting to invest today. Of course, much depends on the ability to maintain a steady rate of return. This is why an advisor is an important part of achieving your financial goals. A professional will help steer you to the right investments and help you stay the course.

About David M. Darst, CFA

Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.

Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.

David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.