“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
– Albert Einstein
The easiest way to look at compounding interest is to use the rule of 72, which is that you take your rate of return, divide it into 72, and that will tell you approximately how quickly the investment will double in value. If you could find an investment that would give you a guaranteed rate of return of 7%, and you invested $100,000, then in 10 years your investment would be worth about $200,000, in 20 years it would be worth about $400,000, in 30 years it would be worth about $800,000 and in 40 years it would be worth about $1,600,000!
The power of compounding returns is in how long the investment is given to compound much more than the amount of the investment. That is why I encourage everyone to start saving as early in life as possible, even if it is not very much. If a 20 year old could save $5,000 a year in her 20s and 30s, then stopped saving, and earned an average of 7% per year, then she would have about $1,800,000 by the time she reached 70, which may be enough to retire on, all based upon an initial investment of only $100,000 over a 20 year period of time. By comparison, someone that does not start saving until age 35 would have to save $12,000 a year for 35 years (for a total of $420,000 invested) in order to have approximately the same amount saved at age 70.
Of course, there are no investments that I am aware of that are currently guaranteed to give you a 7% return per year indefinitely. Sources of near-guaranteed returns are U.S. government bonds, savings accounts, and some highly rated corporate bonds, but anything above a 3% return right now would be surprising, and it takes about 24 years for an investment returning 3% per year to double in value. This is part of why I am enthralled with dividend paying stocks. U.S. stocks have returned 7-10% or more on average per year over most 10 year periods in history. Significant research indicates that over long periods of time companies that pay a dividend, and increase that dividend each year, tend to outperform companies that do not pay a dividend or that decrease the dividend. There are many logical reasons to support this research, such as the belief that a consistent dividend payment requires company managers to focus their retained profits only on the most profitable opportunities rather than seeking to reinvest all of the profits to grow the business, including making bad deals.
It is important to understand that a dividend is the only payment you receive in exchange for owning a stock. The other form of a return is a change in the value of the stock, but that change can be up or down, sometimes significantly, and you only get the benefit of that change when you sell the stock. A dividend, on the other hand, can be reinvested immediately to buy more shares of stock (thereby compounding your investment), such that when the next dividend payment is received, you are getting a greater dividend payment than the prior payment because you now have more shares. That greater dividend can be used to buy more stock, which then means a bigger dividend the next quarter and so on. Ideally, with a dividend paying stock that increases its dividend every year, you get to compound your investment four times per year (since most companies pay dividends quarterly) and the amount of that dividend goes up once per year, which is a fifth time per year that you get to compound your investment.
With a company that doesn’t pay a dividend, you have to trust 1) that the company is able to reinvest those profits and compound them effectively (most don’t); and 2) that the stock price reflects that success at the time you want to sell your stock (which is subject to millions of factors other than the your expected fair value of that stock at that time).
My preference, which is based on my study of Warren Buffett and other great investors and academics, is to own companies that pay a dividend that increases every year and that are very efficient with the profits that they retain. If I can find a company that pays a consistently growing dividend, is efficient with its retained profits, and is trading significantly below what I believe is the fair value of its stock price, then I will look into it in more detail as a possible buy.
Certainly, this same concept can apply to other income paying investments, such as bonds, certificates of deposits, and even possibly rental property. The key is to make compounding interest work for you so that you can obtain financial freedom as soon as possible.