Power of Compounding

There are two great quotes attributed to Albert Einstein regarding the most powerful forces in the universe.  He described black holes as “they are where God divided by zero.”  I guess if a force is strong enough to destroy the fabric of space and time itself it would definitely be worthy of being one of the most powerful forces we know of.  The other quote is attached to him, however, there is no absolute evidence he did say it.   The quote is along the lines of when someone asked him what the most powerful force in the universe he replied compound interest.  Since I know close to nothing about black holes I figured it would make more sense for me to talk about compound interest.

There was a great article I read a few years back on compound interest and I wanted to steal and then share some of the points.  Compound interest is defined as interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan.   While our brains are great at linear analysis we are not as natural when it comes to exponential thinking.  Let’s dig into a great example.

The article cited an example from The Art of Thinking Clearly.   Imagine a piece of paper is folded in two.  Then it is folded in half again.  And again.   And again.  How thick will it be after 50 folds?  Oh, for anyone trying to calculate this imagine the paper is .004 inches thick.  Based on this thickness and 50 folds the paper will be roughly 60 million miles thick.   Yeah, 60,000,000 miles!  In case you are wondering, it is the distance from the Earth to the Sun.  Oh, and it takes over 8 minutes for light to travel that same distance.

The author wrote about the power of compounding after he admittedly was joking that the Dow could hit 2,000,000 by 2099.  Another financial writer pointed out this was possible.  To achieve this the Dow would have to compound at 5.7% for the next 83 years.   Considering the Dow has grown an average of 7.14% annually for the last 75 years he believes it is possible to hit Dow 2,000,000 by the turn of the century.

Warren Buffett attributes a large portion of his wealth to the effect of compounding.  At age 30 he was worth $1 million.  At age 59 he was worth $3.8 billion.  Now, at age 93 he is worth roughly $130 billion.  Not shabby at all.

While you may not achieve the wealth levels of Warren Buffett and I am not convinced you will be able to fold a piece of paper in half 50 times, I am confident if you have a strong investment strategy you can take advantage of the laws of compound interest.  In the meantime, avoid those get rich quick scams which seem to simply be the financial industries versions of black holes.