To understand the awesome ‘Power of Compounding’ let us do some fun maths.
Let us take an example of Kid A, who gets a supposedly great paying job for a 20-year-old at $45,000 per annum. He actually survives on the same $15,000 a year that Kid B, going to med-school, survived on. Now let’s assume that the 20-year-old who skipped med-school for that great paying job invested the remaining $30,000 of his salary in stocks.
Here are the facts:
The med-school student. Kid B, graduates ‘on time’ at the age of 28; secures a job paying $75,000 a year and pays all of his debts off by the age of 33—so theoretically, he’s 33 before he actually has an effective salary of $75,000.
Kid A, who skipped med-school and invested in stocks, earned the historical average of 10.1% annually on his money (10.1% since 1926…but if you skip the Great Depression years the average is actually closer to 13%). So, where is this kid at the age of 33? He has $920,180 dollars in compounding assets. Coupled with his $45,000 annual salary, he will earn $135,000 at the age of 33 while the doctor earns $75,000.
The doctor cannot mathematically catch up to the scrub (Kid A) who’s still at his 45k year salary (maybe more). 13 years hence, he has about 122k to reinvest in the market that year while the doctor will never be able to match that investment; he will always play the catch-up game no matter how much he may earn.
But none of this actually happens, does it? That kid, A doesn’t invest, and the doctor stays in debt. The statistics mentioned above are just used as a guide to elucidate a point; it does not mean that the right education doesn’t give fruitful results. .
What’s the point?
The point is that understanding compounding, and starting out early makes you wealthy. It’s surprising they don’t teach real-life economics in school.
The Golden Rule of Accumulation and power of compounding is – START EARLY. Time, without a doubt, is the most important powerful weapon in an investor’s arsenal. There is nothing that comes close to it.
“When you’re young, you have an asset money can’t buy: TIME. Start saving now and turn pocket change into riches.” (Erin Burt, 2007)
The power of compounding accelerates and creates a snowball of money. At first, your returns may appear unsatisfactory, but if you’re patient, eventually, your initial investment will grow enormously.
Effect of a Small Increase in Interest Rate
Another important facet of compounding is that a small change in the rate of return can produce a huge impact over time. For instance, if you gift your newborn son $10,000, and if his portfolio returns 10% annually, then your original gift of $10,000 will grow to $4.5 million by the time he is 65.
But if his portfolio returns 8%, then it grows to only $1.4 million. On the other hand, if it returns only 5%, the portfolio will increase to a mere $227,000. In other words, if the rate of return is halved then, the portfolio will be less than 1/20th the size.
This is a very crucial to remember—a minimal percentage change in interest rate can have a huge impact on the final outcome. So when you are investing or borrowing money for real estate/business, negotiate interest to the second decimal point. Banks and financial institutions understand this because it is their bread and butter. So should you, because if you do not negotiate hard no one will give you an inch.
In the game of money, he wins who understands money the best.