How to Get Rich - The Beauty of Compounding to Investors and Companies

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." - Albert Einstein.

I’m always amazed by the mechanics and impact of the compounding effect. The basic compound interest formula is:-

Where:

F = Future value or final value of the investment
P = Principal or the starting capital
r = Annual rate of return
t = The number of years this return is compounded

To let the compounding effect work its wonder, an investor needs to focus on the Starting Capital (denoted by P), Annual rate of return (r) and the number of years (t). Let’s use $100,000 starting capital, 10% annual return and 20 years as baseline inputs for comparisons with other permutations. For simplicity, effects of inflation are neglected throughout.

Effects of Compounding with Various Inputs

As observed from the table and chart, for all cases the value of gains is much more than the initial capital itself. But what can we really learn from these results and what can we do to maximize the compounding effect?

I find it quite worthwhile to classify these inputs based on the level of control we have over them. By identifying them singularly, we can find out which inputs we are lacking and categorically work on them.

Time Factor (t)

As observed above, time is an absolute critical factor for the effects of compounding to snowball the initial capital as much as possible. All of the input invested 7 years late did worse than the baseline input. If we have $100K and can compound 10% for 20 years but we do it 7 years later, our gains is a 57% or $327K lesser! 7 years later is 7 years too late. This is something that we can control only when we are still young. The key is to start investing as early as possible and have the patience to let the compounding effect work. 

To put it into practical perspective, if a 40 year old who earns an average of $100K per year invest with baseline results, he will have an extra $245K by 53 years old. This would mean that his investments gave him an extra 2.45 years of working income. However, if he started 7 years earlier at 33 years old, he will have an extra $570K by 53 years old which also means that he gets an extra 5.7 years of his working income. Why work another 5.7 years when you can actually get the same amount of money with less effort? Retiring a few years earlier is certainly not bad at all!

Starting Capital (P)

The Starting Capital is also important but comparatively less controllable. Different individual profiles will have differing amounts of starting capital to invest. Most of the time, we can’t really control how much we have at the start (especially when we are young). However, all of us have universal control in terms of the proportion of our money we set aside to save and invest. This is a definitely a decision that can be made and acted upon for almost everyone.

Return Factor (r)

Can we really achieve 10% returns per annum for our investments? No one knows. Sometimes its luck and other times it may be because of innate talent. I believe the best way to potentially improve anyone’s returns is through continually seeking and acquiring investment & financial knowledge. This is definitely something within our control. There are many books, articles and videos online and offline that teach us how to make our money work harder for us. Of course, this takes time and effort but I think it’s the only way to handle this factor properly.

The Real Trick – Combining All 3 Inputs

What’s the use if we can earn an impressive return from our investments but we can compound it for only 2 years? There’s also little use when we have 30 years to compound our money when we can only achieve a 2% return. The real trick lies in combining all 3 inputs in the compound interest equation. To do this, we first need to tackle each factor separately by (a) Identifying which factor we are lacking the most, (b) Find out what we can do that is within our control to improve the factor, (c) Work on improving them and (d) Repeat the process again starting from part (a). Let me know if you have other ways to optimize the compounding magic :-)

Note: Just want to highlight that there’s another factor that is not included in this simple compound interest equation. That is the additional cashflows you can add into your investment sum every period. Imagine you can compound 10% in 20 years with a starting capital of $100K and on top of that, you are also able to contribute another $12K into your portfolio annually - Your final value would be $1.36M with a contribution of $340K in total. This is compared to the baseline case mentioned above with $672K final value and $100K contribution.

This post is longer than expected. I’ll talk more about the companies which can continually compound their value through time from an investor's viewpoint.