As Albert Einstein once noted, “the power of compound interest is the most powerful force in the universe,” to which he added “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Previously I have written about the importance of compounding, and the need to understand the role of this concept in generating wealth over the long term – this force is arguably the most powerful driver in building significant wealth.
Consider the following: Warren Buffett – the world’s richest investor – accumulated $80.7 billion of his approximately $81 billion net worth after his 50th birthday, according to a brilliant article by Morgan Housel. Furthermore, $78 billion of this $81 billion net worth was generated after Buffett was in his mid-60s. Was Buffett a significantly better investor in the later stages of his investing career, which allowed him to achieve this feat? The answer is no, and the true explanation has to do with the effects of compounding.
Taking a step back, what is compound interest? The concept of compound interest refers to interest that is calculated on both the initial principal, as well as any accumulated interest from previous periods. What this means is that over time, you will be able to earn interest on not just your original principal amount, but the previous interest earned. It’s a fairly simple concept, but its significance is often lost.
The wonders of compounding often go unappreciated in the short term, given that it typically takes a span of years for the true benefits to be realised. In Buffett’s case, the fact that he started investing at such an early age (at 11 years of age to be exact), and managed to amass a significant base of capital early on in his career, meant that the wealth accumulation in the later span of his investing career was immense. By age 30, Buffett had a net worth of $1 million, or $9.3 million when adjusted for inflation. This put him in the 99.99th percentile, and this was notably while Buffett was still young.
Housel runs the numbers on an interesting thought experiment. What if Buffett started investing at say, age 22, rather than at age 11? Would the wealth accumulation be just as impressive?
Let’s assume that Buffett, starting his investing career instead at age 22, was able to have a fairly successful run and hit a net worth that put him in the 90th percentile at age 30. Making some adjustments for inflation, this would put Buffett’s net worth when he was 30 at $24,000, obviously a significantly smaller amount than the $1 million he actually achieved at the same age.
How much would Buffett be worth if he had achieved precisely the same investment returns to date, albeit with a reduced initial base of capital?
The answer is $1.9 billion, an incredible 97.7% lower than his actual net worth. While this is still a lot of money, Buffett would still have needed more than twice this sum to make it onto Bloomberg’s 500 rich list. A corollary of this is that 97.7% of Buffett’s wealth was generated as a result of the significant base of capital he managed to piece together in his teens and 20s.
The above serves as a stark reminder of the importance of being vigilant when saving and making wise investments to compound your capital base. As Charlie Munger once said in his usual blunt manner: “The first rule of compounding: Never interrupt it unnecessarily”. This is certainly advice worth taking, and the sooner you can start building a capital base and tapping into the wonders of compounding, the more likely you will reap outsized financial rewards later in life.
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.