How Compounding Works

Did Einstein really say that Compounding was the most powerful Force in the Universe?

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

Day 1

.02

Day 2

.04

Day 3

.08

Day 4

.16

Day 5

.32

Day 6

.64

Day 7

1.28

Day 8

2.56

Day 9

5.12

Day 10

10.24

Day 11

20.48

Day 12

40.96

Day 13

81.92

Day 14

163.84

Day 15

327.68

Day 16

655.36

 

Day 17

1,310.72

Day 18

2,621.44

Day 19

5,242.88

Day 20

10,485.76

Day 21

20,971.52

 

Day 22

41,943.04

Day 23

83,886.06

Day 24

167,772.16

Day 25

335.544.32

Day 26

671.088.64

 

Day 27

1,342,177.20

Day 28

2,684,354..40

Day 29

5,368,708.88

Day 30

10,737,427.76

 

 

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.

 

I would love to hear your comments below. Thanks for reading and if you like these articles please subscribe to our blog.

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How Dividends Work

Dividends are paid to investors by some companies for their ownership in the company. It is really just a form of profit sharing

How Dividends Work

Many Stocks pay Dividends to investors that own the companies stocks. There are no requirements for a company to pay dividends and in fact some investors prefer that no dividends are payed as they argue that the value of a stock can grow more if the company puts its earnings back into the business itself.Personally I am not in that camp. In fact, I only purchase stocks that pay dividends. There are many advantages to dividends that I have presented here. Advantages of Dividend Paying Stocks.

Dividends are paid to investors by some companies for their ownership in the company. It is really just a form of profit sharing. When you purchase stock of a company you are in reality purchasing shares of a company that represents a percentage of ownership. So if a company issues 1 billion shares you in effect own 1 Billionth of that company for each share you purchase. The board of directors decided how much the company will pay based on a percentage of the profits it earns. If the metrics state that the Payout Ratio for the company is 85% that means they are paying its investors 85% of its earning and the company is retaining 15% of its earnings for use by the company as it sees fit.

Usually a company raises its dividends and some companies even raise it on a yearly basis. Again, there is no obligation for them to do so and no set amount or percentage for it to be raised. This is a decision that is made by the company’s board of directors. Companies have no responsibility however, to pay out the dividends to shareholders and occasionally a company that has a history of paying dividends may decide to reduce the dividend per share or even cut the dividend altogether.

There can be various reasons for a company to reduce or cut out its dividend payments such as needing the money for acquisitions of other companies or it could mean that the company is having financial difficulties. One recent example is that of many oil related companies. Many companies reduced or stopped its dividends when the price of oil plummeted for a long period of time. They were producing the same amounts of their product but the collapse in price on the market meant they could not sell it for the prices they were getting. At one point oil was going for over $100 a barrel and then it quickly fell to under $40 per barrel. This affected their cash flow to the point where many were forced to reduce or stop their dividends.

Dividends can be paid in various ways. Most are paid on a quarterly basis but some companies pay monthly, semi annually or even yearly. Some , mostly foreign stocks, can pay on an irregular basis.

Dividends can also take on other forms such as being paid in the form of stock in lieu of cash.

Some companies also choose to pay out special dividends in addition to their regular dividend payments. This is usually done when a company comes into a larger than expected revenue that it has no current plans for the use of the excess cash so they distribute it to shareholders in the form of the special dividend.

If Company XYZ stock (Company XYZ is a fictitious company) currently pays a dividend of $1.60 a share and pays quarterly it will pay share holders every three months ¼th the $1.60 or .40 cents per share. If you happen to own 100 shares of company XYZ then you would receive .40 x 100 = $40.00 in dividends or $160.00 per year.

If company XYZ paid on a monthly basis you would receive 1/12th of the $1.60 each month or .1333 cents per share you owned each month. In this case 100 x .1333 = $ 13.33 each month.

Companies that pay dividends also issue an ex dividend date and a date of record for qualification of receiving the dividend.  An investor must be an owner of record and own the stock by the ex dividend date in order to qualify for the dividend for that period. This mainly affects you during your initial purchase of the stock as after that 1st period you will have owned the stock for the entire qualifying period. This would also apply to dividends issued in company stock. So if company XYZ pays a 5% Stock dividend each year you must also meet the ex dividend and date of record qualifications. So for the stock dividend company XYZ is this example would be your 100 shares x 5% = 5 additional shares you would receive. The Stock Dividend is rare though and very few companies pay dividends with their stock.

Please share your thoughts and comments below. i love to hear what you think.