The importance of compounding in investing.
Old fogeys like me go on about the importance of compounding in investing but what does it all mean?
Compounding is easy to understand, in principle, but it is quite hard to appreciate the magnitude of its effects, especially in the long run.
Let us illustrate with an example. Suppose Brian invests $10,000 at the age of 18 and it compounds at 12% for 50 years until he retires at the age of 68. Assume he has no other savings, and makes no other provision for his retirement, what money does he have on retirement day? The answer is $ 2.93mn - let us round it up to $3mn. This seems quite a large sum. If he invested another $10,000 at the age of 19, he would have another $ 3mn at the age of 69. In practise, people also save for their retirement during their working life, and this will add further to the retirement pot.
The numbers are large and give some insight into why Einstein called Compounding the “ninth wonder of the world.”
If it is this easy to provide for retirement, why are tnewspapers full of stories about people who have not saved enough for their retirement.?
The answer is compounding needs a number of factors, if it is to work well. There are several difficulties that can derail the steady compounding process described above. We will consider these in detail.