Compounding can offer additional earnings on the reinvested earnings over time
“Compound interest is the eighth wonder of the world.
He who understands it, earns it. He who doesn’t, pays it.”
— Albert Einstein
When Albert Einstein talked about compound interest, I wonder how many people paid attention. After all, it’s not every day that the person who revolutionized our view of movement, gravity and the universe gives us investment advice. Today, we call the phenomenon Einstein was referring to “compounding” instead of “compound interest,” but beyond that there is no difference. To understand compounding, an illustration helps. I’ll share one you may recognize.
Assume you’re considering taking a job that lasts 35 days. Before you make that decision, you want to know how much you’ll be paid. Your prospective employer offers two choices of compensation. You can pick one of the two. You can either be paid $1,000 per day, or you can choose to receive a penny for the first day and then each of the following workdays you will receive double the amount you received the day before. Given these two choices, how do you want to be paid?
If you’re like most people, you want to earn as much money as you can. You know that if you earn $1,000 a day, you will receive $35,000 for 35 days of work. Who would complain about getting a paycheck that large for 35 days of work? Then you consider the second choice. You know there must be something about this offer that doesn’t meet the eye. Unfortunately, you don’t know how to begin figuring it out so you decide to take $35,000.
It’s probably not surprising, but the second choice of compensation would be infinitely more lucrative than the first. In dollar terms, the second approach would pay you $343,597,383.67 which is a great deal more than $35,000. While this example is extreme and unrealistic, it demonstrates the power of compounding because each day after the first, your compensation compounds at 100 percent per day.
As luck would have it, compounding is a process that is available to all of us. The first law of investing states that investors earn returns on their investments in three ways: interest, dividends and capital appreciation. This law of investing tells investors that the way they take their investment returns significantly affects their ultimate success.
Consider an investment-related example where an individual puts money in an investment or savings account that pays a set amount of interest every month. If the investor chooses to receive the monthly interest in the form of a check, his annual return will be calculated by dividing the 12 months of interest he receives by the amount of principal he initially put in the investment or the savings account. On the other hand, if he leaves his money in the investment or savings account, the amount of interest he earns every month will be determined by the balance of the account, which is growing larger with every monthly interest payment. In other words, monthly interest is calculated on the initial investment and the interest that has been accumulated in the account.
While the previous example illustrates how interest compounds, investors who receive dividends and/or capital gains may also benefit from compounding. For example, consider the investor who receives a dividend payment from or realizes a capital gain on an investment. If he reinvests some or all of those dollars in the same or another investment that pays interest, dividends or capital gains, he will benefit from compounding because he’s earning a return on the initial investment and the returns he’s earned on the initial investment.
Investors who understand compounding are well equipped to take advantage of the phenomenon Einstein called the “eighth wonder of the world”.