- Compounding is a powerful force that allows investors to obtain “interest on interest”.
- If used wisely, over long periods compounding can lead to exponential growth in wealth.
Manhattan for a Dollar
Everyone knows the story of the Dutch settlers that purchased the land that is now Manhattan from the American Indians, but here’s a quick refresher. As the story (or more likely myth) goes, in the year 1626 (392 years ago), Dutch settlers traded beads and trinkets worth about $24 with a group of American Indians in exchange for what is now this almost priceless island in New York. It’s worth noting that many parts of this story are highly debated, including what was actually traded, and how much it was valued. Notwithstanding, at first glance, listeners to this folktale are given the impression that the Dutch settlers obtained what may be considered the biggest free lunch in history.
But the story doesn’t end there. In part two of this tale, we learn that had the American Indians actually invested this paltry $24 in the financial markets (using E-Trade, of course), then today the ancestors of these natives would be able to purchase back Manhattan from its current owners and still have money left over.
Some quick math can drive this point home. Take $24 and compound it with a 7% annual return. As a proxy this is around the average return for the S&P 500® Index since inception in 1928, with dividends reinvested and adjusted for inflation, but you can play around with these assumptions here. And after 392 years, you get an impressive sum of $7,918,667,257,948. That’s almost eight trillion dollars.
The Magic of Compounding
The reason this final sum is so large is because of the magic of compounding. As a quick example, take $100 and compound it for three years at 10%; ultimately, you don’t end up with $130 ($10 a year), but rather you end up with $110 after the first year, then $121 after the second year, and $133.10 after the third year. This extra $3.10 is basically “interest on interest”, and although it seems small, after long periods, this effect can be tremendous.
Compound interest (or compounding interest) is interest calculated on the initial principal and which also includes all of the accumulated interest of previous periods of a deposit or loan. —Investopedia
There are some wild assumptions backed into the analysis above, and who knows how much it would cost to actually purchase Manhattan, but my main point is that investing over long periods of time can lead to exponential growth in wealth. Just for fun, had the starting amount been $100 rather than $24, then this initial investment would have grown to almost $33 trillion dollars over the same period.
In Finance 101, this story conveys the first lesson of the magical powers of compound interest. This force is so strong, it lead Einstein to famously conclude the following:
Compound interest is the most powerful force in the universe. — Albert Einstein (maybe)
This quote has never actually been verified; nevertheless, the ramifications of this patent insight are truly mind-boggling. Imagine if your late-late-late-grandfather had left you some small sum of not-too-great-of-a-significance in an investment account over a hundred years ago. Imagine what that paltry sum could be worth today. You my lucky friend, would no longer have to worry about money. That’s the simple power of Investing Forever.
In my next post, we’ll explore how this very example would have played out for one very lucky (although hypothetical) great-great-great-grandson. I trust that you find the results insightful, even though you already know where I’m going with this.