Investing for the Long Term
Albert Einstein purportedly called compound interest the “eighth wonder of the world,” and stated that “He who understands it earns it; he who doesn’t pays it.” And while Einstein was likely not the originator of this quote, the sentiment still rings true today.
The effect of compound interest across our capitalistic, free-market society is staggering. It can bring unimaginable fortunes, as well as insurmountable debts. Some people understand its power; few people actually apply it to their life. It is the grease that enables our national economic machine, for better or worse, to continue into the future.
“He who understands it earns it; he who doesn’t pays it.”
Compound interest is typically regarded as affecting people’s wealth and finances, mostly because of the quantifiable nature of money. It is the reason investing in the stock market for the long-term has been extremely profitable. If compound interest is the way to becoming wealthy, then holding investments over many years is the action (or in reality inaction) needed to achieve it.
In this piece we are going to talk about why long-term investing works and why it is the best method to build wealth. I am also going to talk about how compound interest affects every aspect of your life, in a positive or negative way.
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What is Compound Interest plus some Examples
According to Investopedia, the definition of compound interest is “interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan.” Simple enough, right.
Let’s apply this principle to investing. If you invest $1 and achieve a 10% compounded annual growth rate, after 30 years you will have $17.45. Or, in larger terms, over a 30-year time span you can “magically” turn $100,000 into $1.745 million. Pretty great if you ask me.
But here’s the where the real magic comes in. Say you double the time period to 60 years. At a 10% compound interest rate, $100,000 becomes $30.4 million (excluding taxes). That’s some retirement money right there!
That is the power of true long-term investing. The problem is, not many people have been able to sustain a 10% annualized return rate over 40, 50, or even 60 years. It takes a person with a certain amount of patience, skill, and demeanor to achieve extremely long-periods of compounded growth. People like Warren Buffett and Charlie Munger.
Buffett and Munger
Every investor has likely heard the story of Berkshire Hathaway (and if you haven’t I’d think about another profession), so I’ll keep this short. Warren Buffett and Charlie Munger’s firm, along with a ton of other executives, have achieved a 20% annual return since 1964, turning Berkshire Hathaway into a $500 billion company and Buffett into one of the richest men in the world.
Unlike most people, Buffett truly understands the future costs of his present actions.
It is the classic example of why investing the right way for the long-term will almost assuredly beat any other method of wealth creation. I also think that most fans of Berkshire Hathaway are just sheep pretending to be contrarians, but that is a story for another post.
Buffett can offer plenty of wisdom on a myriad of subjects, but there’s one skill that I think many people have overlooked throughout the years. Unlike most people, Buffett truly understands the future costs of his present actions.
Now or Later
I believe that if people understood the outcome of their actions, we would have a lot more rational decision-makers in our midst. This happens in every part of life, which we will get into later, but for now, let’s stick with investing since it creates such quantifiable scenarios.
Let’s say you go out for coffee every morning instead of making it at home, a $2 more expensive daily habit. If you switched to instant coffee you would save around $730 a year, right? That’s not how someone like Warren Buffett would look at it. Applying that money to pay down debt (compound interest working against you) or investing it can bring you way more financial security in the long-run than $730.
The real question a 20-year-old needs to ask themselves is: Do I want o spend $730 on unnecessary bullshit or have $200,000 when I’m 80? I think some people might reconsider their $3 latte when they realize the true long-term consequences of their simple, daily decisions.
Compound Interest is Omnipresent
Compound Interest is not only a financial phenomenon but a universal one. From reading to learning to exercise to addiction to sleep to health to relationships, everything is affected by the simple concept of growth on top of growth.
Skeptical? Let’s go through some examples.
Bill Gates said that reading 50 books or more a year gives him a distinct knowledge advantage and helped him build his billion dollar fortune. But Gates did not become one of the wisest men in the world because he read 50 books in one year; he is one of the most knowledgeable humans on earth because he is able to apply what he reads to the thousands of books he has already read.
Each sequential book you read is more important than the previous one, for the simple reason that the knowledge obtained can be applied to a wider base. This works the same way for writing, which ironically is what I am doing right now. It is growth on top of growth.
Another easy albeit less joyful example is addiction. People become addicted to heroin, sugar, social media, even cheese. Whatever it is, the addict becomes enthralled by the substance because of the hormonal rush it provides to the brain. At first all you need is a little boost, but then things start to compound (see what I did there?). You start needing 10x the original hormonal boost to get the initial return and eventually end up obese, smoking a pack a day, or worse. It’s growth on top of growth.
It’s the exact same principal as compounding your wealth, it’s just negatively applied to a more qualitative scenario. Everyone out there has some debt being compounded, and the quicker you realize what it is the happier you will be.
I’m actually thinking of writing a piece strictly on how compound interest applies to almost any situation. If interested please comment on what ideas you would like me to apply compound interest too.
Apply the Principles of Long-term Investing to Everything
In my opinion, the best way to improve in anything is to apply the principles of long-term investing. Want to become more flexible? Practice 15 minutes of yoga every morning. Want to complete a marathon? Start running every afternoon and steadily increase your mileage. Want to build long-term wealth? Invest $50 into a broad-based ETF every week with Acorns.
Overnight successes don’t happen overnight. The top dogs in any field are able to sustain success over the long-term because they’ve used the power of compound interest to obtain distinct advantages over their opponents.
I personally try to invest for the long-term in anything I do and hope others reading will try to as well.
Disclosure: The author is not a financial adviser, and may have an interest in the companies discussed.