🥇 Everything you need to know about compounding

Compounding is the eighth wonder of the world.

Those who understand it, earn it. Those who don’t, pay it.

Learn everything you need to know about the power of compounding in this article.

A penny that doubles every day

Let’s say that you have the choice between two sums of money:

• $1 million in cash

• A penny that doubles every day for a month

Which one would you choose?

Does the above sound like a difficult question to you?

Let’s give you a hint.

A penny that doubles every day would be worth $0.16 on day 5 and $5.12 on day 10.

You will probably know that a penny that doubles for a month will be worth more than $1 million. Why else would I ask you this question?

Well, a penny that doubles 30 times would be worth more than $10.7 million!

Here’s the math:

Please note that in this example it took until the 27th day (!) for the penny to be worth more than $1 million.

The fact that it took until the 27th day shows you why patience and a long-term perspective are crucial to give the power of compounding the opportunity to work for you.

Compounding works like magic for investing, but also for other aspects in life.

When you get 1% better every single day for a year, your yearly growth would be equal to 37.7x.

Not convinced yet about the power of compounding? Here are a few other examples:

• If you would invest $1 per day for 200 years at 7% per year, you would have more than $6 billion (!) dollar

• When you put 1 grain on the first square of a chessboard, and double it on each square until the 64th one, you would have 1.4 trillion metric tons of rice. This is more than 2000x the global production of wheat per year

• The cost of Columbus’ journey in 1492 was approximately $30.000. When this $30.000 would have been invested until today at 4% per year, it would be worth more than $33,000,000,000,000 ($33 trillion)!

Compounding explained

You’ve already learned that compound interest is the eighth wonder of the world.

Compounding works like a snowball. It starts very slow, but the longer you keep rolling, the bigger it gets.

Let’s say that you invest $10,000 and you are able to compound your money at 7% per year.

In year 1, you’ll make $700 ($10,000 * 7%). As a result, the value of your portfolio is equal to $10,700.

In year 2, you’ll make more than $700. Why? Because you also make money on the $700 you earned the year before. As a result, you’ll make $749 ($10,700 * 7%) in year 2 and the value of your portfolio increases to $11,449.

After 10 years, you’ll even make $1,286.92 (!). This is almost twice as much as in the first year.

When you would invest for very long periods of time (> 20 years), something magical happens.

Remember that you made $700 in year 1 and $1,286.92 in year 10.

Here’s what happens if you keep investing:

• In year 20, your yearly profit will increase to $2,531.57

• In year 30, your yearly profit will increase to $4,979.98

• In year 40, your yearly profit will increase to $9,796.37

• In year 50, your yearly profit will increase to $19,270.95

If you would keep your $10,000 investment for 50 years, your investment would almost be worth $300,000!

Furthermore, your yearly profit of $19,270.95 would almost be twice as much as what you invested in the first place.

Formula compound interest

On the internet, there are a lot of compound interest calculators you can use. The Calculator Site is a good example.

Here’s an example where you would invest $10,000 at 9% per year for 40 years while adding $200 per month to your investment account (total investment of $106,000 over 40 years).

When you would do this, you would have $1.3 million after 40 years, as you can see here:

Obviously, you can also calculate it yourself.

Here is the formula for compound interest:

If you would invest $10,000 for 20 years at a yearly return of 9%, it would look as follows:

Final amount = $10,000 * (1,09)^20
Final amount = $56,044

In the table below, you can find out how many times your wealth compounds at various combinations of yearly returns and years.

When you can for example achieve a yearly return of 12% for 30 years, your money will increase 30-fold (!).

Start as early as possible

You’ve learned that the longer you can compound your money, the better.

This also means that the sooner you start investing, the longer compounding can work like magic for you.

Let’s use an example to make this even more clear.

In our example we have 2 men who start investing:

• Ben

  • Starts investing at age 21

  • Monthly investment: $200

  • Stops contributing money at age 30 (added money to his account for 9 years)

• Joey

  • Starts investing at age 30

  • Monthly investment: $200

  • Keeps investing until age 67 (added money to his account for 37 years)

In total, Ben will have contributed $21,600 while Joey will have contributed $88,800 to their investment account.

When Ben and Joey both keep their investment until age 67 and manage to compound at an average annual return of 11%, Ben would have $2.1 million while Joey would have grown his account to $1.2 million.

This means that Ben would have almost twice as much money as Joey while he contributed only one-fourth of what Joey contributed!

Source used example: ramseysolutions.com

Never interrupt compounding

Charlie Munger once said that the first rule of compounding is to never interrupt it unnecessarily.

You don’t believe Charlie?

You should. Let’s use one more example:

• Olivier

  • Starts investing at age 21

  • Monthly investment: $200

• Emma

  • Starts investing at age 21

  • Monthly investments: $200

  • Stops investing at age 30 and starts again at age 40

This is how their wealth would like if they both keep investing until age 67 and achieve a yearly return of 11%:

• Olivier: $3,3 million

• Emma: $1,1 million

As you can see, Olivier would have 3 times as much money as Emma just because Emma decided to stop investing for 10 years.

Source visual: Roberto Ferraro

Conclusion

That’s it for today. Here’s what you should remember:

• Compound interest is the eight wonder of the world

• Start investing as early as possible

• You can calculate compound interest via this formula:

  • Final amount = beginning amount * (1 + yearly return)^number of periods

• Never interrupt compounding unnecessarily

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About the author

Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. We have read over 500 investment books and spend more than 50 hours per week researching stocks.