Buffett, Compounding and The Rule of 72

"The most powerful force in the universe is compound interest"

This is allegedly a statement made by Albert Einstein. Many people argue if those were the exact words, but almost all agree that he said something to that effect. However, there shouldn't be an iota of doubt in anyone's mind about the truth in what is being said.

Warren Buffett and Peter Lynch, two legendary money makers, who made tons of money without making stuff, but by making deals/decisions; both of them have emphasized the power of compounding in their businesses and are reaping the benefits. It would be way too naive to say that compounding was the biggest reason of their success; however, it would be fair to say it had a crucial role to play.

Buffett owned his first stock at the age of 11, but says,
"I don't know why I wasted time before that stock…I got started late."

For quite some time I used to think this statement as plain rhetoric, but now having read a book about his investment philosophy I realise how serious he was and I have no doubt in my mind that he truly believed what he said.

Investing is a complex thing, and it involves among lot other things, the risk of losing your capital. But there are many investment vehicles (like PPF) that are safe and most of us invest in them, but generally that happens after gaining some financial wisdom but losing a considerable amount of time in the process. For all of us, all we had [have to, if you are still young :-)] to do was [is] invest early and forget.

To give an idea, 1 Lac invested at a rate of 12% for 30 years will become approximately 30 lacs. If you are lucky and could earn a 20%, that would be 2.4 crores!

If you think these numbers are high, think again. Historically, Sensex has returned more than 18% to date.

Here is a sheet that shows the results of compounding a sum of money at a certain rate for certain years. Have a look and you will realize that over a long period, how money transforms itself. The sheet contains three tabs:
1. SIP - calculations for a systematic investment plan (for fixed rate of interest)
2. Summary Amounts - compounded amounts for a principal, rate of interest, duration.
3. Summary of growth - growth of money as a factor of the principal amount.

The intensity of Buffett's love for compounding can only be matched by his hate for taxes. He considers tax to be one of the biggest holes in your pocket. Not surprisingly, he tries every trick in the book to save tax. There was a news story about him paying less tax than his secretary (in terms of %). He was taxed at 17% while his secretary paid @ 30%. http://business.timesonline.co.uk/tol/business/money/tax/article1996735.ece

He considers the money lost in tax to be a double loss because not only you lose some of your earnings, you lose the amount you could have made using it. If a company is doing well, he would prefer the company to not pay a dividend and keep growing.

Before I close this post, here is a 'nifty' tip for your compound interest calculations.

The Rule 0f 72:
The number of years you need to double your money = 72/ (rate of interest in %). For mathematically inclined, here is how/why it works. http://www.moneychimp.com/features/rule72_why.htm

Link to the excel sheet for compound interest and SIP calculations

Comments (28)

One more important thing which makes a lot of difference is discipline and consistency. I guess falling into a habit of saving/investing could also make a lot of difference. SIPs are definitely a good way to achieve both consistency and discipline.

Absolutely, imo power of compounding is actually the power of disclipline (i.e. staying invested). My initial idea of this blog was to relate it to the power of discipline in real life. A small good habbit over a period of years may become a formidable skill/core competency/usp.

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