Compounding, the process by which money grows exponentially when each year's return is earned on all prior interest and principal, is often called the eighth wonder of the world. Compounding has been the key to every great investor's success, from Philip Carret to Warren Buffett.
With a so-called lost decade in stocks just behind us, many are now doubting its existence. Some are wondering if compounding is a vestige of a bygone era, like cassette tapes and Twinkies. Truly, compounding has never left us. Consider this: Given the recent recovery in the stock market, the past ten years has delivered an annualized rate of return of 7.15 percent with dividends reinvested. This led to a doubling, a 100 percent return over that period. Given the turmoil of the past several years, this is a remarkable result. Those who simply stuck out the last ten years, and didn't panic and sell during the depths of the financial crisis, doubled their money since 2003. Even if you had invested 15 years ago, not long before the start of the greatest secular bear market since the Great Depression, you would have compounded money at 4.72 percent per year. This also would have doubled your money.
To test your knowledge of this extraordinary phenomenon, take this short quiz:
(1) If money compounds at 10 percent per year for ten years, the resulting gain is:
a. 88 percent
b. 100 percent
c. 159 percent
d. 120 percent
(2) If you invested $10,000 in the S&P 500 fifty years ago, today you would have:
(3) If you had invested $10,000 with Warren Buffett fifty years ago (first in his limited partnership and then in Berkshire Hathaway), today you would have more than:
Answers: (1)c (2)d (3)b
If you're wondering whether those are typos -- or you're just kicking yourself for not having been prescient enough (or born early enough) to have invested with the Oracle of Omaha in 1962 -- you're hardly alone.
A few other remarkable facts:
- $1 invested in stocks a century ago is now $10,680
- $1 invested in gold a century ago is now only $83
- $1 invested in a savings account a century ago is now only $34
The power of compounding is still with us. And it will be with us over the next 50 years as well. The disadvantage of compounding has always been the same: it requires tremendous patience. The supercharged returns only come over long periods of time. It requires waiting out wars, depressions and recessions. It relies on the discipline to avoid "timing" the market, which is the surest path to missing out on compound returns. In sum, it's as slow as molasses and as boring as watching paint dry.
And it's a minor miracle -- in a world that could use one or two.