Understand compounding or compound growth.

Einstein described compounding as,

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Warren Buffett also has this to say about compounding,

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”

If is is good enough for Einstein and Buffett then it is worth spending 10 minutes reading this then using a calculator or spreadsheet to understand how it works.

What is Compounding?

Compounding is what happens when something grows at a given rate over a period of time. For example, an investment pot of $50,000 growing or compounding at 10% over 40 years will end up worth $2.3m.

It is magic because despite the steady rate of % growth the last few periods growth is huge in absolute terms. Hence why time is so important in compounding. This is a hard concept for humans to grasp as growth does not appear that way in the natural world, things around us don’t grow a constant rates, they slow down as they get big (like trees, plants people etc!)

Grab a Calculator and Try This, It is How I Teach My Kids About Compounding

Key in 1.2 and press the times key twice (the X key twice) and then equals, you’ll see the answer is 1.44. This is the calculation of 20% compounded for 2 periods (which could be 2 years) giving 1.44 or 44%.

Now press the equals key again, this takes the answer and times it by 1.2 again, in effect adding another compounding period. The answer now is 1.728 or 72% growth.

Every time you now press the equals key adds another compounding period. So if you press is 19 times you will be compounding over 20 years. This works out to be 38.33 times or 3833%!

You can change the percentage by changing 1.2 to 1.1 for 10%, 1.05 for 5% and so on.

Play around with the number of periods and you will find that the % rate is important and so is the number of periods.

Compounding: Works Both Ways

It means that if you can grow a business or an investment at a steady sensible rate over a long period of time then it will get big.

It also means if you get into debt and it starts building up due to unpaid interest payments, it also gets big very quickly.

Compounding Your Knowledge

Imagine if you could learn at steady 10% per year, that means each year you learn way more in real terms and you get exponentially smarter!

View my original answer on Quora

Tim O'Shea
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Tim O'Shea

Fund Manager with 15 years' experience as a successful business owner-manager. Passionate about helping people benefit from the power of long-term investing.
Tim O'Shea
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Tim’s Newsletter October 2016