Compounding refers to “interest on interest”
Excerpt From “Seeking Wisdom From Darwin To Munger”
If we invest $1,000 with a return of 6% a year, we receive $60 in the first year. If we reinvest that $60, next year we get another $60 from our original $1,000 investment, plus $3.6 from the $60 we reinvested. If we reinvest all our returns, the total value of our original $1,000 investment after 5 years is: $1,000 * 1.06 * 1.06 * 1.06 * 1.06 * 1.06 = $1,338.
Time is the key to compound interest. Over short periods, compounding produces a little extra return. Over long periods, it has an enormous effect. Invest $2,500 each year for 40 years at 10% return and you will be a millionaire.
Excerpt from “Buffet Partnership, Ltd – January 18, 1963”. Buffett wrote this under the title ‘The Joys of Compounding’ and hence I used the same title for this post.
I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.
The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.
| 5% | 10% | 15% | |
| 10 Years | $162,889 | $259,374 | $404,553 |
| 20 Years | $265,328 | $672,748 | $1,636,640 |
| 30 Years | $432,191 | $1,744,930 | $6,621,140 |
I wanted to teach the power of compounding to my elder son who is 10 years old. I gave him the following choices
- Receive 1 cent on Day 1 and every day I will double what he had on the previous day. I will stop this on Day 30.
- Receive $100 every day. I will stop this on Day 30.
He chose Option 1 wisely which made him richer by just $5,365,709.12
| Day | Double every day | $100 every day |
|
1 |
0.01 |
100 |
|
2 |
0.02 |
200 |
|
3 |
0.04 |
300 |
|
4 |
0.08 |
400 |
|
… |
… |
… |
|
27 |
671088.64 |
2700 |
|
28 |
1342177.28 |
2800 |
|
29 |
2684354.56 |
2900 |
|
30 |
5368709.12 |
3000 |
Seeking Wisdom 