The 8th Wonder of the World – Compounding Interest
I would like to take a look at the concepts of compounding and inflation. The principles of the two are identical. One works for you in a positive growing way, the other in a silent negative manner.
Let’s take a look at inflation first.
We all experience inflation; we do not have a choice in the matter. Inflation is the sustained increase in the price of goods and services, or to state it differently: the sustained degradation in purchasing power per unit of money, and therefore the real loss of value. The average rate of inflation over the past 100 years is about 3%. What that means in a real and very practical sense, in approximately 20 years your dollar will lose about ½ of its value- a silent but deadly destruction of the value of our cash. This is alarming, and can impact your life style especially in your retirement years, as your dollar buys less and less over time.
Let’s take a look at compound interest next.
I am sure that we all have heard of The 7 Wonders of the Ancient World. A quote, commonly attributed to Albert Einstein, names compound interest as the 8th. You might not be familiar with how he ended that quote though: “he who understands it earns it, and he who doesn’t pays it.”
What makes compound interest such a powerful force?
Let me answer that question with an illustration. Say you meet someone on the street and they offer you a choice between two gifts: $1 million dollar today, or 1 penny today but they will double that gift every day for the next 30 days. That would mean 1 penny today, two pennies tomorrow, then 4 pennies on the third day, then 8, 16, 32, 64… and so on. Which would you choose? If you chose the $1 million and put it in your savings account paying 0.10% interest, at the end of the 30 days you would have $1,000,083.33. But if you chose the penny doubling every day for 30 days, you would have received $5,368,709.12! – Over 5 times the value of the day one gift of $1M dollars! An amazing illustration of the power of compounding at work to create wealth.
When it comes to investing, it is not just about how large your pot of gold is when you hit retirement. But rather, will your assets create a growing stream of income that will compound over the years, potentially outpacing inflation, supplying you with a growing stream of income that provides ever increasing purchasing power to satisfy your lifestyle needs. We apply these concepts in our investment strategy of Growth of Income through owning companies that pay a growing stream of dividends.
Maybe you have heard of “The Rule of 72”. If not, it is a simple mathematical formula: if you know at what rate something is growing, divide that number into the number 72, and you will know how long it will take for its value to double.
As I just mentioned, our investment strategy involves owning strong companies that have paid a consistently larger dividend over time. Applying “The Rule of 72” then: if a company increases on average the dividend by 7% per year over an extended period of time, the amount of income generated in your account will double approximately every ten years (72 divided by 7). If the cash generated by these dividends can grow at 7% per year, and inflation is 3% per year, we are not just creating more cash every year, but more importantly, creating more purchasing power year after year. And remember that dividends are a return of company profits to the shareholder, not the results of the movement of the markets or the price of the stock.
A potential doubling of your income every ten years, regardless of the action of the markets or even the underlying stock position… a true wonder! The Eighth Wonder of the World – compounding!
As I mentioned at the beginning, we all will experience the negative impact of inflation. My question for you is: will you choose to take advantage of the power of compounding income?
