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The Awesome Power of Compounding

This article will be simple, yet it could be one of the most important things you’ll ever read. And while the concept may seem rudimentary, it is extraordinarily powerful. This is how true wealth is created—not by excessive trading or via arcane investment strategies. No, true wealth is built by compounding your money over time. It’s really as simple as that.

An Example

For the purposes of this illustration, we’re assuming we have two college friends, each of whom just turned 21. Investor A (Bob) decides to spend his extra money on new clothes and parties each month for the ensuing seven years, while Investor B (Mary) lives more conservatively and instead starts each year by putting $2,000 in her discount brokerage account. (For more, see: Investing 101: The Concept of Compounding.)

Next, we’ll assume a compounded annual rate of return of 10%, which is a bit high, I understand, but you’ll get the idea. After seven years, Mary’s portfolio is worth almost $21,000, while Bob has nothing. Upon hearing of her accumulated wealth at a New Year’s Eve party, Bob finally gets with the program and starts to save that same $2,000 each year. At the same time, Mary decides it’s time to start enjoying herself a little more, so she no longer saves that $2,000. Forty years goes by, after which time Bob and Mary get together over drinks to compare notes on their lives. Mary’s portfolio was then worth $930,641 with only the original $14,000 invested, whereas Bob’s portfolio is worth a smaller $893,704, even though he had put in $80,000 over those 40 years.

So as you can see, thanks to the incredible power of compounding, Mary made 66 times her money, while Bob only made 11 times his money, simply because Mary started sooner and allowed her money to compound. That is how you build wealth. (For more, see: Why Dividends Matter.)

Now I realize that it’s not possible to earn a constant 10%, or any percent for that matter, every single year. Some years you’ll make more, others years less. Yet the concept, and the math, is both powerful and irrefutable. (For related reading, see Portfolio Returns: What's Reasonable to Expect?)

Takeaways

So what does this mean for everyday investors? The first takeaway is to start saving early. The earlier the better. The second is to reinvest your interest and dividends. Third, and related to the last point, is to invest in companies that pay dividends, and preferably, increase those payments every year. One of the greatest investors of the last 50 years, Warren Buffett, built his fortune by compounding his investments.

I have tried to incorporate the same basic strategy into the way I manage investments on behalf of my clients. I buy solid, dividend-paying stocks, reinvest the income, and continue to hold the stock for as long as the investment thesis remains intact, thereby deferring taxes, which also helps you compound your income.

This isn’t rocket science. But it does require discipline and patience. It isn’t sexy but it is the surest way to accumulate wealth. So if you haven’t already done so, get started right away. (For more, see: The Greatest Investors: Warren Buffett.)