What is Compounding?
When I was in grade school one of my memories goes back to a teacher that used the famous “doubling penny” story to illustrate compounding to our class. It was for some reason a very memorable lesson for me. For those of you that have never heard the story it goes something like this –
Our teacher asked us which would we rather have – a million dollars (remember this was back in the early 60’s – a million dollars was something huge back then, you could purchase a loaf of bread for .25 cents ) or a penny …. That doubled every day for 30 days. Of course we all immediately said the million dollars. After all we were not stupid … or were we? Well let’s do some math and find out if we were stupid or not.
A Penny Doubled Every Day for 30 Days
Turns out we were not as smart as we thought we were. If we had gone with the penny that doubles every day in just a month we would have collected almost 10 million more dollars.
As you can see compounding has miraculous qualities! Now of course to achieve the example above you would have to receive an astronomical interest rate that is compounded daily and of course that is just not real. But it does get the point across as to the real world power of compounding, especially when it comes to investing. Notice what the single most important factor is in the above example – Time! Remember my saying “Time is an investor’s best friend” and of course the rest “yield is an investor’s second best friend”. Perhaps I should amend my statement to state “An investor’s three best friends are Time, Yield and Compounding”!
Einstein was quoted by many as saying that “Compounding was the most powerful force in the universe”. Did Einstein really say that Compounding was the most powerful Force in the Universe? I was unable to substantiate whether or not he actually said this but from my point of view he would have been absolutely correct to say this. Let’s look at another example that illustrates the power of compounding and time.
Let’s look at the example above and see if we can learn anything from it. The first thing we should notice is how very little change takes place during the first 20 days. After the first 20 days however there is an explosion in growth and again after day 25. What does this mean to us as investors? Well, first let’s change this from a daily chart to a yearly one. What we should observe is that compounding is constantly working its magic but it takes time to actually observe the explosive changes. What this should tell us is that we have to have patience when investing and that just the mere factor of time will bring us the results of compounding we deserve. This is where the human factor keeps us from exceeding with our goals. Many people lose focus and cannot keep working towards their goals. Staying focused and goal oriented is the number one factor in achieving them. If you were to give up on day 20 – look at the chart and see how much you are losing.
I encourage everyone to set their goals. Track your progress on a monthly basis. Make a chart similar to the one below. Plug in your own numbers and goals so you can see where the end result is and what you will lose if you give up. Compounding is not only wonderful but it can be a lot of fun to experiment with also.
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