Albert Einstein is often quoted as saying that “compound interest is the eighth wonder of the world.”
What this quote understands is something fundamental about investing: compounding can turn relatively ordinary returns into extraordinary results, provided you give it enough time.
The basic idea is simple. You earn a return not only on the money you originally invested, but also on the returns you have already made.
Imagine investing $10,000 and earning 8% a year. After the first year, you have $10,800. In year two, you don’t earn 8% on your original $10,000, you earn it on $10,800. That takes you to $11,664. The following year, your return is earned on this still larger amount.
Nothing particularly exciting seems to be happening.
But keep going.
At 8% a year, $10,000 becomes approximately $21,600 after 10 years, $46,600 after 20 years, $100,600 after 30 years and $217,000 after 40 years, without another cent being added.
One of the best ways to understand why it is so powerful is an old story involving a chessboard and some grains of rice.
Imagine placing one grain of rice on the first square of a chessboard, two on the second, four on the third, eight on the fourth, and continuing to double the amount on every square.
At first, the numbers look almost laughably small. By the tenth square, you are placing only 512 grains of rice on the board. Even after 20 squares, the amount is significant but hardly unimaginable.
Then something remarkable happens. By the 32nd square, you need more than two billion grains for that square alone. Continue all the way to square 64 and the total reaches roughly 18 quintillion grains of rice. This is more rice than is produced in the world.
The point isn’t the rice. It is the shape of the journey.
Compounding is difficult for human beings to intuitively understand because our brains tend to think in straight lines. If something grows from 10 to 20 over one period, our instinct is to imagine 30, then 40, then 50.
Compounding doesn’t work like that. It seems to grow slowly, and then surprisingly quickly.
This has an important implication for investors: time is an extraordinarily valuable asset.
Investors understandably spend enormous amounts of time worrying about what markets will do next month, which fund will outperform this year, or whether they should wait for a better entry point. But over a sufficiently long investment horizon, simply allowing returns to compound can matter enormously.
Consider the difference between earning 8% for 20 years and earning it for 30. The additional decade doesn’t merely add another $8,000 of returns to our original $10,000 investment. It takes the portfolio from roughly $46,600 to more than $100,000.
And this is why patience can be so powerful. The early years of compounding can feel frustratingly uneventful. Much like the first few squares of the chessboard, not much appears to be happening. The temptation is therefore to interfere: trade more frequently, chase whatever has recently performed well, or abandon a sensible investment after a disappointing period. The really powerful part of compounding occurs later.
Successful long-term investing doesn’t necessarily require constantly finding the next great opportunity. Sometimes one of the most important things an investor can do is much simpler: own productive assets, reinvest the returns, and give compounding the time it needs to work.
Patience isn’t doing nothing. Patience is allowing the mathematics to happen for your benefit.
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