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Compounding returns – the eighth wonder of the world

Albert Einstein is reputed to have said: ‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.’

As an investor, making your money work for you is the best way to increase your wealth. And the wealth you will accumulate is the result of two things: how long you invest and the rate of return on your investment. We work with Clients and their investments on a weekly basis and it never ceases to astound me the impact that time and compounding can have on investment values. We often recommend they switch off the computer and come back in five years and look at the results.

To do this you will also need psychological qualities to make the whole thing work. Qualities like being patient, disciplined, knowing the value of things, and being able to act decisively when the herd is behaving differently. Why is compound interest so ‘magical’? The simple answer is: ‘Because it’s reinvested’. Compound interest is, simply put, interest on interest.

Here’s an example. Assume you invest $100. The following table shows how much return you’d get over different lengths of time, and at varying rates of return.

Source: Morningstar

If you invest $100 at 5% over 5 years, you get $128, but if you wait 10 years, that amount rises to $163. The longer you wait, the more you make! Of course, this goes even higher if you can get a higher return. For example, if you can find an investment that returns 15% for 10 years, you multiply your money by a factor of 4. If you wait for 20 years and still earn 15% a year (which is a lot), you get 16 times your money back.

Twenty-percent seems like a very high unachievable return. Actually, it’s pretty rare, reserved to the most talented investors, such as Warren Buffett (the annual return of per-share market value of Berkshire Hathaway has been 20% per annum, over 55 years…).

Two factors to remember.
If you want to accumulate wealth, you will need to start as early as possible and then focus on the best prospective return you can find.

The second factor is obviously the most difficult to get, because it depends on careful study of key elements such as the price you pay for the assets in which you invest, and their intrinsic qualities. This is very much the work we do. Looking at whether the price is right.

Importantly, you can’t control the market.
Cheap valuation is also not an element you control. It’s usually the reflection of other people’s opinion, aka ‘Mr. Market’ sometimes agrees to pay a lot for a company and at other times is willing to sell at a huge discount.

Patience is a virtue. While prices look expensive, the market will throw up opportunities. You just need to be positioned for that eventuality and by buying at the right price you set yourself for the future and the power of compounding comes to the fore.

Have a great week!

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