A First Look at Compounding

Excerpted from The Single Best Investment
Compounding Is the Money that Money Makes
At the risk of sounding repetitive and boring, I’ll say this again: the Single Best Investment strategy is not about “playing the market.” It’s about being a partner in an enterprise, and beyond that it’s really about creating a kind of compounding machine that sits quietly off in the corner working for you while you go about your business. It’s about harnessing the true power of time and growth, the incredible accumulation of modest gains into enormous ones, which is the essence of compounding.

The gains are like bricks: you slowly and carefully place one atop the other. By and by—though not instantly—the shape of a building emerges. Once you’ve got strong structure, the building can last many lifetimes, and you can furnish it with valuable antiques and art, or add rooms, or change around the partitions to make a new floor plan. Many people can’t wait. They want to throw up a plywood pre-fab in a weekend. But that’s like a shelter in a fable; in a strong wind there’ll be nothing left save a pile of rubble.

However, the bricks of this compounding building aren’t like the bricks you know. These bricks have the ability to generate new bricks, like a living thing. And these bricks can grow larger, like a living thing. And the bricks that they generate can grow larger, too. It is fecundity on earth, it is fruitfulness, it is multiplying, it is increase, it is like the universal process of cell division and proliferation that’s ultimately behind the very creation of our bodies.

Compounding is the money that money makes, added to the money that money has already made. And each time money makes money, it becomes capable of making even more money than it could before! This is called a virtuous circle, and it’s what we want to get working for us.

Simple vs. Compound Returns
Let’s say I have $1,000, and I am able to achieve a return of 10% per year through investing it.

The simple return over ten years would be $1,000. I would receive $100 per year—10% of $1,000 for ten years, to reach the total of $1,000. If an investor pays $1,000 to buy a ten-year bond, for example, and receives $100 in interest each year, which she spends, she has received simple interest of 10% per year for 10 years. At the end of that time, the investor has the original $1,000 (repaid when the bond matures) and now needs to look around for a new investment which, hopefully, will also pay 10% interest.

The compound return works differently. Here we assume that the money earned by the investment is reinvested in the same investment, rather than spent. In this case, after the first year the investor would have the original $1,000, plus an additional $100 (the earnings) generating returns. Let’s assume that all of the earnings could be reinvested at the same original rate. Over ten years the compounded return would look like this:

Since the investor started with $1,000, the total gain for the ten years was $1,594, versus $1,000 in total earnings for the simple return. In other words, the reinvested, or compounded, return was 59% higher.

Since as we know from the simple return example the actual earnings were $1,000, another way to look at this is to see that the earnings on the investment earnings earned 59%. This is what we mean by saying that money makes money, and that the money money makes, itself makes money. If you think of your capital as “working” for you, you can easily see that in a compounding situation you also get to have your capital’s children working for you (and the children’s children, and their children after that). Only in the world of pure investment, there are no child labor laws. You can work those little fellas twenty-four hours a day, and you should.