Compounding! What is it? Isn’t it just a myth? Is it for me?
Compounding is a word many of us have heard before, maybe even read about, or played around with. But how many of us truly understand the power of compounding when done right; and how few of us really incorporate it into our decision making and have it ingrained into our DNA.
Albert Einstein supposedly once said ‘Compound Interest is the Eighth Wonder of the World. He who understands it, earns it … He who doesn’t .. pays it.’ Whether he did say it or not, doesn’t matter, because the message still stands.
Gut Feeling Test
I would like to offer you 2 investment types, and you only have 1 second to answer; which would you choose:
- You invest $100, and after 1 year I pay you $1 interest per day on the $100
- You invest $100 and every day I owe you 0.5% interest daily. I will only pay you at the end of the 365 days.
Simple, some might say. 0.5% of $100 is only 50 cents, so why would I take 50 cents when I can have $1.
If I were to give you 0.5% every day, meaning that I only ever owe you $100 at any given point, the total interest would only be $182.5 over the whole year. However, as I mentioned I would pay you back only at the end of the 365 days, the amount of money I owe you, would increase over time.
Let’s have a look:
|Beginning of Day||$ Amount I Owe you||0.5% of Amount I owe you|
As you can see, the daily interest that gets added to what I already owe you, increases daily. So whilst it starts off slow, with only receiving $0.50 interest on the first day, you can see that by the end of the 365 days, you are receiving $3.072 interest.
In the below graphs, you can see a visual representation of the total value of your investment with scenario 1 vs scenario 2, as well as the daily interest paid.
Total Value of Investment over 365 days
Daily Interest Accrued over 365 days
Okay, so now that I have your attention, I will go a bit more into how compounding works, and how you can make compounding work for you and your goal; whether that’s early retirement or a shiny new lambo.
The 3 Forces that affect compounded returns
As we have seen in the table and graphs above, the longer you compound your interest for, the greater the power of compounding.
- On the 12th August 1982, the S&P500 index closed at 102.42.
- 39 years later on the 12th August 2021, the index closed at 4460.83
- This is a return of 4355.42%
- Sounds like a lot in 39 years; but this only equates to roughly 10% a year. Or roughly 0.026% a day.
- Just over 8 years ago, on the 5th of July 2013, a single Bitcoin would have only cost you $68.43.
- At the time of this writing; you would have to pay just over $43,000.
- In roughly 3009 days; Bitcoin went up 62,800% (CRAAAZYYYY)
- This equates to around 220% per year, or a measly 0.21% a day.
Compounding Return Rate
Obviously, the rate of return you get on your investment, will make a big difference for your end result. And the higher the rate of return, the higher the effect of compounding.
Let’s compare 2 hypothetical scenarios:
- Makes 0.1% return a day. Reinvests all of his returns
- A $100 investment, over 365 days, would yield a profit of $44.025; i.e. 44.025%
- Makes 0.3% return a day. Reinvests all of his returns
- The same $100 amount invested in Trader 2 instead of Trader 1, would generate a 44% return already after 122 days. After 365 days, your return would be $1,984, a whooping 198.4%.
As you can see, a higher rate of return per day, translates into a much higher return after 365 days. Whilst the daily return of Trader 2 is only 3 times as high as Trader 1, the return after 1 year, is 4.5 times as high as Trader 1.
All of us have certain expenses we need to make, whether that’s rent, taxes or buying new wheels for our 1 month old Lambo (surprisingly they are quite affordable, at ONLY $2000 for a set of four tyres). So it would be unfair of us to discuss compounded interest, without assuming that investors would have to withdraw some money every now and then.
Again, let’s assume 2 hypothetical situations. Based on our above scenarios, we believe that Trader 2 is the better investment, and we come up with the following strategies:
- Trader 2 makes us 0.3% a day. Reinvests all of his returns.
- After 1 year of compounding these daily returns, our $1,000 investment is worth $2,984
We withdraw $1 a day to pay for a cup of black coffee:
- Every day, we make the same 0.3% as above, but we withdraw $1 for our coffee.
- At the end of the year you’d have $2,322. So whilst you’ve only spent $365 total on the daily coffee; you are actually $661 worse off.
- The below graph shows the difference between withdrawing and not withdrawing
Maybe Boomers are right when they tell us to stop drinking coffee so we can afford to buy a house.
So, now that we hopefully have a better understanding of compounded interests, I would like to give a few examples of how we can use it in our everyday life, from personal growth to your investment decisions.
Long Term Investment
We all dream of early retirement, or at least of more financial stability. And wouldn’t it be nice if we just knew which NFT or asset would be the next 1000x? Unfortunately, for most of us, this is a dream that will not come true. For every 1000x opportunity, there are countless more that burn up and make us lose money rather than make.
It might seem like every day we see someone posting on social media; how they bought that new Tesla or Lambo with their Dogecoin winnings, or from buying and selling silly JPEGs; but if you are wanting a more guaranteed win, slow and steady wins the race.
Probably one of the most famous investors to date is Warren Buffett; with a net worth of 100 billion, we’re probably assuming he’s had some magic help and he’s definitely had to have gotten lucky with a lot of 100x or 1000x opportunities, right? What if I told you, that Berkshire Hathaway’s (Buffett’s Investment Firm) best year in the last 20 years was a measly 33% return on investment? And his worst; -17%. His personal net worth also rarely had a massive jump year on year, and as you can see from the graphic below, it was a slow, but steady uptrend.
It’s often quoted that his average annual return was just 20% (compared to 10.2% for the SP500).
Over 50 years, a 20% return would yield a return of just above 9000x, whilst a 10.2% return would only generate a 130x over the same 50 years.
Lesson – Getting rich quick is possible, especially in Crypto; but it’s more luck than skill. True skill is playing the long game, and aiming for a sensible rate of return year on year; over many years.
The Loss of Not Staking
Most people that will read this article, have at some point in time checked out StakingRewards; so staking is not a foreign concept. Every now and then, when I go to crypto MeetUps; I am perplexed at the lack of stakers in the community. And when I inquire as to why they are not staking, rarely is the answer lack of knowledge, or lack of information.
Most of the time Crypto Investors/Traders tell me that the small annual reward is dwarfed by the huge increase in their general crypto portfolio, especially when one considers the effort required to stake – sure, 15% a year compared to a 10x increase in underlying asset price is not much, but it adds up. 10x a year is not feasible for more than a few years. In 2020 the world GDP was just shy of 85 trillion USD. Just a single $1 invested, would grow to more than the world wide GDP in under 14 years if the investment would grow at 10x a year. (1 * 10^14 = 100 Trillion)
Let us assume that you will, however, find an investment that over the next 10 years does a 1000x; and a measly 15% return a year doesn’t seem worth the effort for you. You put in $1,000 which after 10 years, is now worth $1,000,000. Great! Awesome! You’re a millionaire.
Now imagine, you had staked this asset for the whole duration; and on average receiving 15% a year; what would be the total worth of your $1,000 after 10 years?
$1,000 * 1000 * 1.15^10 (~4) = roughly $4,000,000
So, even though your staking is only generating 15% a year, at the end of the 10 years you now have 4 million dollars instead of just the 1 million.
So, by not staking, you just lost out on $3 million dollars worth of extra income.
I’m sure you have heard people say this before, but just a 1% increase in personal growth, happiness, etc would mean an increase of 37x after just 1 year. If you are not happy with your salary, or your activity level, or anything else in life; it is easy to want to make drastic changes quickly to improve asap; but usually this backfires, same as with your investments.
Similarly, just a 1% worsening of any element of your life per day, would mean that after just 1 year, you are 97.5% worse off than at the beginning.
I like to call this the rule of 1%. Small changes, steadily over time will have a greater effect on your education, your finances and any other aspect of your life than trying to make big, drastic changes once and trying to stick to them.
Compounding – Conclusion
The best way in my opinion to approach compounded interest is to set yourself a goal with a time limit. For example, if you want to retire in 25 years at the age of 50 with a Net Worth of $5 Million, and are aiming to add $1,000 to your investment account every month; what annual return do you need to make this a reality.
We start with $0 on our account at the moment. We assume that every month we add $1,000 into our account for 25 years (300 months). This brings your total investment amount to $300,000.
In this case, you would need to average a 18.7% annualized return on your investment, to bring the Total Value of your Investment to $5,000,000. (potential tool idea?)
So, whilst small daily improvements and interest might seem trivial and too small to matter; when you look at your long term goals you start seeing that in fact these small things are what makes the difference.