Understanding the power of compounding
Gaining a greater understanding of compounding can put you on a pathway to financial freedom.
If you have even a peripheral interest in investing you’ve probably heard the term compounding. You likely even know what it means—earning returns on returns. And you may even know that Einstein called compounding the “8th wonder of the world.”
Einstein almost certainly didn’t say that but attributing the quote to a person synonymous with genius is telling.
While the term is thrown around in investing circles ad nauseum there is a difference between knowing something and understanding something.
To understand compounding start with a simple table which will serve as a base case for this article. Below is the impact of an investor saving $10,000 annually for 40 years and earning a 7% return.
The return is steady which isn’t how volatile markets work. But the example is still illustrative of the impact of compounding. For the purpose of this example I’ve assumed the $10,000 is invested on the first day of the year.
Several things are apparent from this table. The first is that compounding can be very powerful. In 40 years, a total of $400,000 was saved and invested. That turned into $2.136m in wealth.
Looking at the last two columns of the table shows the percentage of the annual increase in wealth that can be attributed to new savings and to returns.
In the first row of the table 93% of the increase in wealth is based on savings. Only 7% comes from market returns. These percentages reverse in the last row of the table. Market returns make up most of the wealth creation.
The implications should be clear. When you are young every dollar saved has a significant impact on future outcomes. When you are older savings don’t matter as much and returns are the driver of wealth creation.
This contrasts with how many people approach their finances. Saving and investing when you are young is easy to dismiss by telling yourself you will make up for it later when you ‘make more money’.
This point is highlighted by making some adjustments to the table. The following shows what would happen if you stopped saving after the first 20 years. Half as much was saved but 80% of the total wealth from 40 years of saving was created.
In the next table I’ve done the opposite. In this case the hypothetical investor did not start saving and investing for 20 years. Once again half as much was saved but in this case only 20% of the total wealth from the base case was created.
An adjustment can be made to highlight the impact that returns provide on total wealth creation. The following table shows a scenario where a 4% return was earned over the first 20 years and a 10% return was earned over the last 20 years.
Over the full 40-year period the average return is exactly the same. It is 7%. In this case total wealth was 27% higher.
In the following table I reversed that scenario. Once again the average return was exactly the same but 10% returns were earned over the first 20 years and 4% was earned during the last 20 years. Total wealth created has now dropped from the base case by 20%.
Returns are always important but they matter more later in life. This further reinforces the importance of saving early in life and investing better later in life. And while there are lots of things each of us can do as investors to get better returns you need to acknowledge the role that overall market returns play.
The luck - and yes, it is luck - of having a strong bull market later in an investing journey will have a huge influence on overall wealth.
This understanding of compounding has further implications on the way you should approach our finances.
When is the best time to speculate or blow some money on a purchase
It is often said that when you are young it is the time to take financial risk. You might hit it big. And if not, you will have time to make it back. An understanding of compounding exposes the fallacy of this bit of conventional wisdom.
Take a punt and lose $10,000 on a speculative investment in year 5 of the 40-year timeframe and it isn’t $10,000 that you need to earn back. It is a bit more than $114,000 by year 40.
Blow $10,000 on some extravagant purchase that doesn’t bring joy to your life and it is the same result. And that mindset matters. What you are spending and what you are risking on some speculative bet matters a lot more. Lose $10,000 in year 35 and all that is needed to make it back is a bit over $14,000 by year 40.
Obviously $10,000 is a significantly smaller portion of total wealth at the end of this hypothetical 40-year scenario.
Yet what remains true is that squandering money when you are young is not just about the money. What is really being squandered is time. And if compounding teaches us anything it is that time is the most valuable resource in investing.
Course correcting later in life is hard
Getting somebody at the beginning of their career to focus on retirement is challenging. Luckily in Australia we have compulsory employer contributions into super but many workers don’t fall under the mandate. It is easy to procrastinate and focus on the immediate challenges you face. This tendency makes things harder later in life.
Compounding is a powerful driver of building wealth. The proof of that power is how difficult it is to course correct as time frames get shorter. This is demonstrated by modifying one of the scenarios that was previously explored.
Only saving for the last 20 years of the 40-year time-frame results in a significantly lower level of wealth than saving for the first 20 years or the entire period.
Modifying this scenario slightly shows the difficulties of course correcting later in life. If an investor does not save for the first half of the 40-year time period but wants the same total wealth it is much harder to do.
Assuming the same return of 7% per year it would require saving $48,696 a year from year 20 to 40. That is significantly more than saving $10,000 a year.
Starting to save and invest early provides optionality later in life. And having options is a form of freedom. In this case an investor who starts early can have the same retirement outcome with close to $39,000 more of spending each year later in life.
Each year it becomes a little more difficult to make up for not doing something earlier. Even small amounts of savings can make a big difference when we add the element of time.
Savings and investments are not the only thing that compounds
In an investing context compounding is a good thing. It is how you turn small amounts of money into large amounts of money by simply adding the element of time. Wealth is not the only thing that compounds. Debt compounds as well.
It is an age of abundant credit. And the companies trying to sell stuff have an advantage over the average consumer. The companies understand compounding and the consumers don’t. Almost any purchase can be magically transformed from a lump sum that a consumer would balk at into an affordable monthly payment.
This magical transformation involves interest that negatively compounds a $1000 couch into a $2000 couch. Every magic trick needs a flourish to distract the audience from what is happening. And in this case it is the combination of the emotional rush of buying stuff and the affordable monthly payment.
Many goods and services involve emotions. It isn’t just a suit. It is the way you will look and feel in that suit during a big job interview or a special date. This same emotional pull influences purchasing decisions on vacations, cars and houses. These are all items that are often funded with borrowed money.
Purchasing certain items requires borrowing money. Houses and cars are the most obvious example. Everyone needs a place to live and a car is a necessity for many people. And this isn’t a call to not finance either purchase. Just a reminder that when emotions are combined with seemingly affordable monthly payments it is easy to lose sight of the real cost. Stretching your budget for a certain house or adding some features to a car can cost far more than you think.
Final thoughts
Each reader will interpret this article in different ways. Everything is seen through the prism of cumulative experiences and personal circumstances. Some readers will feel pride that, knowingly or unknowingly, they took advantage of compounding by starting early. Some will feel regret for squandering time.
And some will feel pressure. As you get older and your portfolio gets bigger the consequences of mistakes and poor returns increase. Understanding compounding can bring this truth to life. Many readers of this article will be responsible for their own finances or the finances of their family. These readers will understand this feeling.
Wealth is not the only thing that compounds. Pressure compounds as well. The weight of the responsibility to provide for yourself or those you love grows as the stakes get higher.
You are the one that family and friends turn to with questions about money. You are the one that is supposed to have the answers. Yet sometimes there are no answers. There is simply the mathematical reality that forms the basis of compounding and unknowable future market returns.
Take solace in the one truth that compounding teaches. This truth applies now and it will be true in three months. Time is an investors most steadfast alley. The answer to when is the best time to save and invest will always be today.’
Tell me your lessons about compounding at mark.lamonica1@morningstar.com
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