Compound interest: The Eighth Wonder of the World
"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it."Compound interest is often called the eighth wonder of the world, a term attributed to Albert Einstein. He famously stated, "He who understands it, earns it. He who doesn't, pays it." While this might sound like an exaggeration, the math behind it reveals its profound truth.
Example:
- Simple Interest (no interest on interest effect): $1,000 invested at 10% annual interest for 5 years = $1,500, as each year the interest earned is $100 ($1,000 * 10%), so 5 years total interest earned = $500, plus $1,000 initial investment, total value at the end of 5 years is $1,500
- Compound interest (with interest on interest effect): $1,000 invested at 10% annual interest for 5 years = $1,610, which ends with 7% more gain than the simple interest investment strategy.
In the context of stock investments, compound returns are similar to compound interest but account for fluctuating annual growth rates. The reinvestment of dividends and capital gains creates a compounding effect. In this article, we are going to use returns from Berkshire Hathaway and S&P 500 Index to illustrate the compounding effect.
- Berkshire Hathaway (historical annualized growth: ~19.8%)
- S&P 500 Index (historical annualized growth: ~10.2%)
- Berkshire Hathaway: $1,000 grows to approximately $6,089.
- S&P 500 Index: $1,000 grows to approximately $2,641.
The Formula for Compound Growth
The formula to calculate the future value (FV) of an investment with compounding is:
Where:
- FV = Future Value
- PV = Present Value (initial investment)
- r = Annual growth rate (decimal)
- n = Number of Years of Investment
- Initial Investment: $1,000
- Growth Over Time (1964-2023):
- Berkshire Hathaway grew to over $43 million
- The S&P 500 grew to approximately $311,000
Tips for Harnessing Compound Returns
- Start Early: Time is the most critical factor. Even small amounts invested early can grow significantly over time due to compounding.
- Be Consistent: Regularly invest and reinvest returns to maximize the effect.
- Stay Invested: Avoid interrupting compounding by pulling out investments prematurely.
- Focus on Growth Rates: Higher growth rates are highly desirable as they can significantly enhance long-term outcomes. However, it’s crucial to ensure that the growth is both sustainable and consistent over time. Unstable or unsustainable growth can undermine the compounding effect, while steady, reliable returns allow compounding to work its magic most effectively.
Wealth Multiplier: The Rule of 72
Before wrapping up on the compound interest topic, I would like to introduce you to the wealth multiplier, Rule of 72. The Rule of 72 is a simple yet powerful shortcut to estimate how long it will take for an investment to double in value, assuming a fixed annual return rate. By dividing 72 by the annual percentage growth rate, you can quickly calculate the approximate number of years needed to double your investment.
Example:
- At a 10% annual growth rate, it will take approximately: 72 ÷ 10 = 7.2 years to double your investment
- At a 6% annual growth rate, it will take approximately: 72 ÷ 6 = 12 years
Conclusion
Whether you're investing in individual stocks, ETFs, or mutual funds, the magic of compounding is your greatest ally in building wealth, making it a powerful tool for wealth accumulation. Compounding is not just financial concepts; they are powerful tools for achieving financial independence. By understanding and applying these principles to your investments, you can unlock exponential growth, turning even modest investments into significant wealth over time.
As Albert Einstein aptly called it, the ‘eighth wonder of the world,’ compound interest empowers anyone to transform modest investments into meaningful wealth over time. Start now, stay the course, and let time do the heavy lifting for your financial future.
Below is the chart to visualize the compound effect of investing $1,000 since 1964 on Berkshire Hathaway and S&P 500 Index respective. In the future I will also be writing a blog specially on the topic of dividend, dividend reinvesting and why dividend reinvesting is critial.
Berkshire Hathaway and S&P 500 Index Performance Data
* Dollar amounts in the last two columns are based on $1,000 initial investment from 1964. S&P 500 returns already included dividend reinvestment.
| Year | Berkshire Growth (%) | S&P 500 Growth (%) | Berkshire Growth ($) | S&P 500 Growth ($) |
|---|---|---|---|---|
| 1965 | 49.5% | 10.0% | $1,495 | $1,100 |
| 1966 | -3.4% | -11.7% | $1,444 | $971 |
| 1967 | 13.3% | 30.9% | $1,636 | $1,271 |
| 1968 | 77.8% | 11.0% | $2,909 | $1,411 |
| 1969 | 19.4% | -8.4% | $3,474 | $1,293 |
| 1970 | -4.6% | 3.9% | $3,312 | $1,343 |
| 1971 | 80.5% | 14.6% | $5,977 | $1,540 |
| 1972 | 8.1% | 18.9% | $6,463 | $1,831 |
| 1973 | -2.5% | -14.8% | $6,302 | $1,560 |
| 1974 | -48.7% | -26.4% | $3,234 | $1,148 |
| 1975 | 2.5% | 37.2% | $3,315 | $1,575 |
| 1976 | 129.3% | 23.6% | $7,601 | $1,945 |
| 1977 | 46.8% | -7.4% | $11,157 | $1,801 |
| 1978 | 14.5% | 6.4% | $12,779 | $1,917 |
| 1979 | 102.5% | 18.2% | $25,893 | $2,267 |
| 1980 | 32.8% | 32.3% | $34,383 | $2,998 |
| 1981 | 31.8% | -5.0% | $45,323 | $2,848 |
| 1982 | 38.4% | 21.4% | $62,717 | $3,457 |
| 1983 | 69.0% | 22.4% | $105,876 | $4,231 |
| 1984 | -2.7% | 6.1% | $103,000 | $4,489 |
| 1985 | 93.7% | 31.6% | $199,451 | $5,902 |
| 1986 | 14.2% | 18.6% | $227,715 | $7,001 |
| 1987 | 4.6% | 5.1% | $238,178 | $7,356 |
| 1988 | 59.3% | 16.6% | $379,504 | $8,578 |
| 1989 | 84.6% | 31.7% | $700,795 | $11,294 |
| 1990 | -23.1% | -3.1% | $539,321 | $10,943 |
| 1991 | 35.6% | 30.5% | $731,159 | $14,281 |
| 1992 | 29.8% | 7.6% | $949,198 | $15,369 |
| 1993 | 38.9% | 10.1% | $1,317,284 | $16,926 |
| 1994 | 25.0% | 1.3% | $1,646,605 | $17,147 |
| 1995 | 57.4% | 37.6% | $2,590,794 | $23,606 |
| 1996 | 6.2% | 23.0% | $2,751,466 | $29,020 |
| 1997 | 34.9% | 33.4% | $3,708,022 | $38,713 |
| 1998 | 52.2% | 28.6% | $5,644,198 | $49,798 |
| 1999 | -19.9% | 21.0% | $4,523,305 | $60,254 |
| 2000 | 26.6% | -9.1% | $5,727,510 | $54,784 |
| 2001 | 6.5% | -11.9% | $6,099,323 | $48,309 |
| 2002 | -3.8% | -22.1% | $5,867,529 | $37,649 |
| 2003 | 15.8% | 28.7% | $6,796,583 | $48,462 |
| 2004 | 4.3% | 10.9% | $7,089,758 | $53,785 |
| 2005 | 0.8% | 4.9% | $7,147,478 | $56,420 |
| 2006 | 24.1% | 15.8% | $8,865,105 | $65,344 |
| 2007 | 28.7% | 5.5% | $11,415,049 | $68,936 |
| 2008 | -31.8% | -37.0% | $7,783,118 | $43,835 |
| 2009 | 2.7% | 26.5% | $7,992,261 | $55,409 |
| 2010 | 21.4% | 15.1% | $9,707,441 | $63,773 |
| 2011 | -4.7% | 2.1% | $9,252,089 | $65,108 |
| 2012 | 16.8% | 16.0% | $10,812,787 | $75,525 |
| 2013 | 32.7% | 32.4% | $14,347,616 | $99,930 |
| 2014 | 27.0% | 13.7% | $18,225,469 | $113,590 |
| 2015 | -12.5% | 1.4% | $15,944,289 | $115,190 |
| 2016 | 23.4% | 12.0% | $19,665,145 | $129,013 |
| 2017 | 21.9% | 21.8% | $23,970,337 | $157,160 |
| 2018 | 2.8% | -4.4% | $24,641,512 | $150,237 |
| 2019 | 11.0% | 31.5% | $27,351,079 | $197,479 |
| 2020 | 2.4% | 18.4% | $28,007,503 | $233,800 |
| 2021 | 29.6% | 28.7% | $36,290,419 | $300,952 |
| 2022 | 4.0% | -18.1% | $37,741,036 | $246,391 |
| 2023 | 15.8% | 26.3% | $43,715,694 | $311,252 |
Disclaimer
This article is for informational purposes only and should not be considered financial advice. Markets are complex and unpredictable, and various factors beyond valuation metrics can influence future performance. Always conduct your own research or consult with a financial advisor before making investment decisions. Past performance does not guarantee future results.
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