Investing Caffeine

Compounding: A Penny Saved is Billions Earned

October 16, 2009 at 2:00 am 7 comments

What is “compounding” and why is it so great? It sounds like such a fancy financial term. One can think of compounding as a snowball rolling down a hill – the longer the snowball rolls (or the higher up the mountain you begin), the more compounding will expand the size of your snowball. Expanding your investment portfolio through compounding should be your major goal.

Albert Einstein, arguably one of the most intelligent people to walk this planet, was asked to describe mankind’s greatest discovery. His answer: “compound interest.” He went so far as to call it one of the “Eight Wonders of the World.” The benefits of compounding can be demonstrated via famous explorer, Christopher Columbus.

We all know the story, “In 1492, Christopher Columbus sailed the ocean blue.” To emphasize the benefits of compounding, let us suppose that Christopher Columbus made an investment in the historic year of 1492. If Chris had placed a single penny in a 6% interest-bearing account and instructed someone to remove the interest every year and put it in a piggybank, the total value collected in that piggybank would eventually accumulate to more than 30 cents. A pretty nice multiplier-effect on one penny, but not too much absolute cold hard cash to write home about…agreed?

"It's magic, I can turn pennies into billions."

However, if the young explorer had placed the same paltry investment of one cent into the same interest-bearing account, but LEFT the remaining earned interest to compound (thereby earning interest upon the previously earned interest) the results would be drastically different.

What would you guess the compounded account would be worth in 2009?

$10,000? $100,000? $1 million? $10 million? $100 million?

“NO” is the correct answer to all these guesses. 

The correct answer: $121,096,709,346.21! Your eyes do not deceive you. That one penny invested in 1492 would have grown to $121 billion dollars today. If you don’t believe me, pull out your calculator and multiply $.01 * 1.06%, and repeat 517 times. Surely, we will not live 517 years to collect on an investment of such long duration. However, with proper planning everyone has the ability to invest quite a bit more than one cent to significantly build future wealth.

As an advisor, the problems related to compounding I see investors commit most are two-fold:

1)       Investors are constantly shifting money in and out of their accounts (usually at suboptimal points) due to    apprehension and greed, thereby nullifying the benefits of compounding.

2)       Because of overpowering fear relating to current economic conditions, investors are parking their money in low yielding CDs (Certificates of Deposit), savings accounts, checking accounts, money market accounts, or other low returning investment vehicles. This strategy is equivalent to pushing the aforementioned snowball over the sidewalk, rather than down a long, steep hill.

In order to reap the rewards of compounding and dramatically expand your investment portfolio, a systematic, disciplined approach to investing needs to be followed. A system that more likely than not has a 20 year horizon rather than 20 days. Now go start saving those pennies!

Entry filed under: Education, Financial Planning. Tags: Christopher columbus, compounding, investing, Investing Caffeine, Saving.