Your most powerful tool in wealth creation
Warren Buffet described compounding as ‘the most powerful tool in the creation of wealth through investment’.
Compounding or compounded interest can be defined in simple terms as interest on interest.
The result over time is like a snowball effect, where the portfolio starts growing quicker and quicker the longer it’s invested.
Patience and Time
The catch is that the benefits of compound interest require patience and time. This scares many investors who live in a world where everything is instant and people are looking to make a quick buck.
Nonetheless, the returns that compounding creates over time are well worth the wait.
The table below illustrates the powerful effect compounding can have on the investment returns of a portfolio.
It shows the gains of two portfolios called the ‘Spender’ and the ‘Compounder’. The Spender spends all the gains and the Compounder reinvests all the gains.
The difference in the gains of the two portfolios become even bigger as the investment horizon increases. Over a 20-year period the Compounder’s portfolio gain is almost three times the gain of the Spender’s portfolio.
When comparing the gains of a compounder portfolio earning 5% and a compounder portfolio earning 10% over a 5-year period, the 10% compounder portfolio’s returns are slightly more than double the gain of the 5% compounder portfolio.
Over a 30-year period this difference increases to almost five and a half times more.
This shows how important it is to earn additional returns, because over time even a small additional return can result in a much bigger gain.