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Fund Family Shareholder Association
“Compound interest is the eighth won-
der of the world. He who understands
it, earns it…he who doesn’t…pays it.”
—Albert Einstein (maybe)
NO ONE DOUBTS
that Albert Einstein
was a genius, though claims that the
quote above about the wonders of com-
pound interest and the myriad varia-
tions I’ve seen over the years were his
are actually unverified.
Quotably admired by Einstein or
not, compound interest is indeed a
powerful wealth builder—and it under-
pins my philosophy of spending time
in the markets, rather than trying to
time them. Since you and I want to be
the ones earning compound interest,
and not paying it, I thought it would
be worth rolling up our sleeves to get
a better understanding of what com-
pounding is and how it works.
So let’s start at the beginning:
Compounding is the phenomenon of
earning increasing returns on prior
gains, over time. You don’t have to
make a conscious decision to put the
power of compounding to work, though
you can make moves that rob you of its
benefits.
It takes discipline and patience to
reap the long-term benefits of com-
pounding. For one, you need the dis-
cipline to stick with a solid investment
plan
and
to leave your money invested
in the market to build on itself over
time. Patience is necessary, because
early on, the amount you invest far
outweighs the amount earned on those
initial contributions. But as I’ll show
you shortly, those first investments, if
held over long time periods, can add up
to very significant sums as they build
upon themselves.
How Compounding Works
For a simple example of how com-
pounding works, take a look at the
chart at the top of this page, which
shows the growth of a single $10,000
investment assuming an annual return
of 10% over 30 years. I’ve broken
this investment into its three compo-
nents: Principal, interest and com-
pound interest.
In this example, you can see that
in the early years, most of the over-all
value of the portfolio lies in the original
$10,000 investment, or principal (the
dark blue area along the bottom). This
amount never changes, since no money
is being added over time. Gradually,
the 10% return earned on the principal
(the light blue region in the middle)
accumulates at a steady $1,000 per
year to match (after 10 years—10 times
$1,000 = $10,000) and then exceed the
principal.
But it’s what happens in the “com-
pound interest” area of the chart that
is most intriguing (the grey shading on
top). Initially, it’s the barest shadow of
a line because there is little additional
value to compound. Remember, only
$1,000 is “added” each year to the
portfolio from the 10% return on the
$10,000 principal. In year two, we earn
our first compound interest: 10% of the
$1,000 gained in year one, or $100. The
next year compound interests accounts
for a total of $310. Each year thereaf-
ter, the gains generated by compound-
ing keep growing, and this portion of
the overall return becomes a visible,
though still relatively small piece of the
portfolio’s value. Starting in year 15,
the cumulative amount of compound
interest earned exceeds the aggregate
amount of interest received. From that
point onward, those earnings on earn-
ings really take off, driving the majority
of the subsequent growth.
Regular Contributions Kick
Compounding Up a Notch
While the growth of that single
$10,000 investment compounded at
10% is impressive, it’s worth noting
that the real power of compounding
kicks into overdrive when combined
with regular additional contributions
to your account. This is what makes
investing in retirement accounts like
IRAs and 401(k)s so attractive.
Meet an imaginary 65-year-old
investor, Joe, who retired a millionaire
at the end of June 2014. Forty years
ago, on Wednesday, July 1, 1974, as
a 25-year-old with a $12,000 salary
(equivalent to about $57,700 in today’s
dollars), Joe started investing 10% of
his (pretax) paycheck every month
into
Wellington
—a practice he would
continue for the rest of his career. Joe
stuck with the same employer for his
entire career, and was rewarded for
his loyalty with consistent, annual 3%
raises.
The table to the left provides a
snapshot of where Joe ended up, and
as you can see, Joe did pretty well for
himself. His contributions increased
each year in concert with his sal-
ary, but in the end the biggest slice
of his portfolio’s ending value, by a
wide margin, came from earnings on
those contributions and, importantly,
earnings on those earnings. All told,
COMPOUND INTEREST
The Investment Tipping Point
In Time, Compounding
Creates Wealth
Principal:
Your initial investment.
Interest:
Earnings gained on the
principal.
Compound Interest:
Earnings
made off of previous gains.
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
$180,000
$200,000
Account Value
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Years
Creation of a Millionaire
Starting Age
25
Retirement Age
65
% of Salary Invested
10%
Annual Raises
3%
Total Investment
$90,798
End Balance
$1,000,290
% from Contributions
9%
% from Investment Returns
91%
