“The stock market is designed to transfer money from the active to the patient.”
– Warren Buffett
The Value of Compounding
Compounding, in the words of Piet Viljoen, a prominent South African fund manager, is your only friend in the market.
Compounding is one of the few factors over which you have influence and which is also a dependable, safe and predictable way of maximizing your wealth over the long term.
All you need is time and patience.
Equal Nominal Contributions
As an example, one investor begins to invest early, at age 20, contributing R1000 in the first year, escalating in line with inflation for the next 11 years and investing this in the ALSI. She then makes no further payments. The second investor begins investing 11 years after the first, at age 31 (ie. After the first investor has stopped her contributions), contributing an amount equivalent to the early investor’s R1000 escalated by the inflation of the intervening years. He continues to invest amounts escalated by inflation for 34 years until an assumed retirement age of 65.
On retirement, the first investor is actually worth more. Her total investment of just of R14 600 has grown to R13 900 000 compared with R12 800 000 for the second investor, who invested a total of R641 000 – over 40 times more.
Even taking the time value of money into account, which results in the two investors having invested approximately R8000 and R25 700 respectively, the second investor has contributed over five times more but accumulated a lesser amount. (In this discounting, an interest rate of 9.7% was used, the actual average for cash from 1960.)
Equal Discounted Contributions
As a second example, we assume that the two investors decide to contribute amounts that are equivalent after discounting by the time value of money. At retirement, both investors have contributed around R17 000 to R18 000 in discounted terms. The early starter began at age 20 and was able to stop payments at age 45. The late starter began contributing at age 46 and continued until retirement at age 65. Despite both investors having paid in the same real amounts, at retirement the early started is worth R23 100 000 compared with a mere R3 600 000 for the late starter.
One cannot overemphasise the importance of beginning and investment plan as early as possible.
Because the human mind tends to think linearly, compounding (ie. Exponential growth) is unintuitive and difficult to visualize. A traditional example is the lily pond parable, where a pond begins with one lily, doubling every day until it if fully covered after 30 days. Halfway through the month, at day 15, progress is invisible, with only 0,003% of the pond covered. Even on day 25 only 3% is covered. On day 28, three-quarters of the pond still remains open. On day 29, just one day before the end of the month, the pond is only half covered. And one day after month-end there would be enough lilies to cover two ponds. Initial progress is imperceptible; final performance is dazzling.
Compound interest calculations are not new. In 1606 Galileo produced a calculation device of his own design called a geometric and military compass. Among the many uses of the device was the calculation of compound interest and currency conversions.
There is a quick was to estimate[1] the effects of compounding, commonly known as the Rule of 72. To find the number of years required to double your money at any interest rate, just divide 72 by the interest rate. For example, if you want to know how long it will take to double your money at 10% per annum interest, divide 72 by 10, giving an answer of just over 7 years. Conversely, if you want to double your money in 5 years, divide 72 by 5, giving a required interest rate of about 14% per annum.
Compounding is one of the most powerful factors driving long-term returns. Time just happens, but emotional fortitude is required to provide the patience.
[1] This is an approximation for annually compounded interest, designed to be exactly correct at an interest rate of 10%. For continuously compounding interest it becomes the Rule of 69 and is exact (although the mental arithmetic is harder).