The Power Of Compounding by:Julia Lee
How do you turn $30,000 into a million dollars
? The secret is time and the power of compounding. Here I'll run through this powerful concept which has helped Warren Buffett become one of the richest people in the world.
Buffet has long been one of my heroes as the most successful investor in history. But now I feel let down as I read the latest book on Buffet, "The Snowball Warren Buffett and the Business of Life".
There are some great revelations such as realising the power of compounding but the man is obsessed with keeping score of his money and it seems as though it has been at a personal expense.
In fact the title of the book "The Snowball" is a reference to a central theme in Buffett's life which is the concept of compounding.
Let me give you a few examples. All the examples are going to assume an interest rate of 7% per annum with interest being calculated monthly.
Compounding is like a snowflake that rolls into a snowball with time:
$10,000 invested at 7% is worth more than $20,000 in 10 years time.
In 50 years time, that $10,000 is worth more than $300,000.
Of course, that doesn't take into account inflation eating away at your capital but with many stocks offering a 7% yield, the capital growth could mitigate the effect of inflation and in fact beat it.
Such a mindset can be applied to every-day purchases. A $500 handbag is actually like spending $10,000 if you compare the effects of compounding monthly at 7% pa over 50 years. So should I spend the $500 or gain $10,000? It's this type of thinking that has motivated Buffett to put off spending in order to grow his snowball to outrageous proportions.
What about a car purchase of $30,000? Well that would be like spending almost $1 million dollars (50 years, 7% pa with interest calculated monthly). So using that thinking, putting off the purchase of a car could be worth having an extra $1 million in the bank in 50 years time.
It's no wonder that the sharemarket can be so powerful. Great companies are like accelerating snowballs. Not only do they offer dividend payments but also capital growth. Great stocks do better than cash because they are able to return more than just an interest rate of say 7% on their capital. It's not unusual to see a return on equity of 20-30% for good companies.
But I suppose what has struck me most about Buffet is his aim of accumulating cash seems to override everything else in his life by comparison. I suppose he is successful due to his single-minded focus as much as his ability and for that I think he deserves the title of the most famous investor and the richest investor in the world.
As for me, I'd like to take his investing principles and use them not to accumulate as much of a snowball as possible but to balance it against my dreams, my hopes and of course a financially secure future.
Compounding is powerful and the concept of being able to buy into companies can bring great fortune or great grief.
I hope that in 2009 you add great companies to your portfolio and that they bring you great fortune.
Happy trading
About the author
Julia Lee is an Equities Analyst for online share trading platform Bell Direct. Julia provides information on share trading and stock market research for frequent traders and investors.
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