What makes Buffett worth studying is that he doesn’t attribute his success to complex investing techniques like timing the market or chasing Alpha. Instead, he puts it down to an understanding of a simple mathematical force.
Something Einstein referred to as the most powerful force in the world: Compound interest
What is a compounding return? The seed analogy
Let’s talk about money and trees. Yes, trees. They’re a perfect metaphor for compound interest.
Imagine this: You’ve got a plot of land and a dream to grow an orchard of apple trees in ten years. But there’s a limitation: You start with just one seed.
But this seed is special. Plant it, and it gives you an apple tree, plus two new seeds every year. And planting these new seeds has the same result: another apple tree and two more seeds each year. Naturally, to maximise your orchard, you plant all these seeds as soon as you get them.
So, two years down the line, how many seeds do you have? Nine. The original one (still producing two seeds a year), the two it first gave you, and the six from those.
Keep planting these seeds, and in 10 years, from that single seed, you’d have 59,049 seeds. That’s more than enough for an extensive orchard.
This is compound interest in action: start small, reinvest diligently, and watch as your initial investment grows exponentially.
The power of compound interest
Think of the first seed in our analogy as your initial investment, and the act of planting it as making an investment. The seeds that grow each year? Those are your returns. And planting these new seeds is akin to reinvesting your returns, nurturing your investment to grow further.
Compound interest enables your initial investment to earn interest, and then for this new, combined amount to go on and earn even more interest over the following year.
Imagine compound interest as a snowball rolling down a hill, gathering more snow – your returns – with each turn. This snowball effect is what turns a modest beginning into a financial avalanche over time.
How is compound interest calculated?
In our seed-planting scenario, each seed you plant doubles itself every year. This scenario leads us to an astonishing interest rate of 200% per annum.
Real-world investments rarely offer such high returns, but the principle of compounding ensures exponential growth over time with any positive return.
For instance, with a 5% annual return, you would double your investment in about 14.2 years. The formula to calculate this is:
Capital at time t = Capital at time 0 * (1 + rate)^n
Let’s look at one concrete example:
|Amount you start with
|The interest you earn
|How often the interest is calculated
|Once per year
|Amount after 1 year
|Amount after 2 years
|Amount after 5 years
|Amount after 10 years
If you were to receive an interest rate that’s calculated on a shorter period of time, like daily, or monthly, the earnings would be certainly greater too.
Why do we receive compounding returns?
In the world of banking and investing, returns can be thought of as the compensation one can expect for financing someone else’s needs (and assuming the risk that goes with it).
Returns come mainly in two forms:
- Interest: A regular payment made to the lender by the borrower.
- Price appreciation: When the price of what you invested in increases over time
Sometimes the two go hand in hand. But either way, for the compounding effect to occur, the returns you gain must be reinvested.
How to get on the compounding returns train
The most straightforward answer? Investing. Let’s take a common scenario: buying stocks, say Apple shares. Here, compounding returns come from the company’s value shooting up over time, and the cherry on top – dividends, if they’re offered.
Then there are bonds, which typically pay regular coupons (i.e. interest) that you can reinvest. However, their prices also fluctuate over time, which means you could gain returns by selling them at a higher price than what you paid for them.
With a bank account
Another path to compounding returns? Bank accounts that offer interest, like Alpian’s. Park your money into the account, and watch it grow and compound over time.
But watch out: Many bank accounts offering interest rates come with multiple restrictions that block your money over a certain period of time, and have penalties if you withdraw your money before.
Actually, we wrote a full article focusing on interest rates in bank accounts. If you are interested, why don’t you give it a read? “Interest rates: How do they impact you?”
The key factors that influence compound interest
Time and patience
Compound interest is extremely powerful when paired with long periods of time.
To see its power, let’s compare two people who invest CHF 1,000.
- Person 1 invests CHF 1,000 at 8% for 30 years age = 10,000 return
- Person 2 invests CHF 1,000 at 8% for 40 years = 21,000 return
Ten more years of compounding interest doubles the return.
So, let’s go back to Warren Buffet for a second. Even though Buffet’s wealth is not only due to compounded interest, but also to capital gains, he is nevertheless the perfect case study for seeing the compounded rule in action. You see, he’s 93 at the time we’re writing this.
He made his first investment at age ten and never stopped making contributions. That’s added up to 80 years of compound interest… which has done this:
He generated 97% of his wealth in the final 27 years.
There are no tricks here, only the concrete mathematical principles of compounding growth over time.
To demonstrate this in a different way, we ran a quick analysis on the Dow Jones (an index representing the performance of the top 30 US companies). The results show that increasing your holding period tends to reduce your chances of losing money and skew the risk-return profile in your favour:
Compounding is not magical. Picking the wrong investment could mean not receiving any returns (not even the longest holding period can help if the company you invested in goes bankrupt!). The first step is to do your research and pick investments wisely.
In our example, we picked a diversified index of 30 companies. That helped because the returns from high performing companies largely compensated for the returns from low performing companies (not to mention the fact that indices are subject to survivor bias, i.e. only the best-performing companies stay in the indices over time). Running this analysis on any individual stock would yield different results.
This example has worked primarily because the US economy and the price of the index have grown over time (at an average rate of 5.3% per annum over that period). But one can easily argue that, first, there can be a long time where that might not be the case (take the post-depression period, for example) and second, not all economies have been as robust as the US economy.
Compounding interest periods and frequency
Let’s talk about one final factor that impacts the returns from compound interest.
The interest that compounds can be added to your account at different intervals of time, affecting the final result. For example, it can happen annually, semi-annually, quarterly, monthly, daily, or even continuously.
Here’s a key detail: Interest might accumulate daily, but it’s typically added to your balance less frequently, maybe monthly. This addition is crucial because that’s when your interest starts earning its own interest.
For investors, more frequent compounding is beneficial, amplifying their earnings. The bottom line is, that the more compounding periods there are, the greater the effect on compound interest.
How can you make sure to benefit from compound interest?
Here are some simple rules for capitalising on compound interest:
- The more you invest, the larger your returns are likely to be (as well as the potential losses).
- The longer you invest, the larger your returns are likely to be.
- The more consistently you invest, the more likely you are to achieve points 1 and 2. By the way, we use so much the word “likely” because, given enough time, the value of most diversified investments is supposed to rise. However, there’s always the chance that tough market conditions appear around the time that you’d like to cash out of the game! This would mean that you may not be able to exit the investment when you need to, or worse, that you exit with less than invested.
- It’s critical to begin as early as possible because time is the factor that allows compound interest to work its magic
Although, two things are worth refining: First, if you compound your wealth and you are hit by a crisis, you will be hit harder than someone who has not. Second, the compounding statistics rely on a constant rate of return, and there are no such things as constant rates of returns in the markets.
These rules amalgamate into a simple conclusion:
Start investing as soon as you can, and regularly contribute more, obviously to the extent of what you can afford.
The idea of compounding interest is a vital and fascinating concept that is part of the very fabric of investing. If you’re curious to learn more about investing, we have multiple guides and classes within our blog. But why don’t you start with the following article: