Ace investor Warren Buffett has quoted several times that his wealth can be attributed to the power of compounding. He is often quoted for saying, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
But what is compounding, the secret behind Warren Buffet’s vast wealth?
The definition
Compound interest is the methodology of calculating interest in which the interest is calculated on the principal amount plus the interest accrued till that point in time.
An example
To better understand this methodology, assume you put Rs 100 in an investment scheme that pays a 10 per cent annual return on average. So, at the end of the year, you end up with Rs 110. Now for the next interest-earning cycle, the whole amount, Rs 110 would be considered as the principal value instead of just the initial Rs 100. By compounding, at the end of the second year, you have Rs 121, next cycle, Rs 133, next cycle Rs 146 and so on.
The interest received in compound interest grows with time and this makes it an ideal strategy for investors who aim at growing their corpus fast over time.
This approach is far better than the simple interest approach in which you get a fixed interest irrespective of the time period of your investment.
Longer the time period, better the results
Morgan Housel, the author of the popular book Psychology of Money, using an example of the ace investor, highlights how time is the most critical element when it comes to using compounding to grow one’s wealth.
The author points out that Warren Buffett’s investment has an average 22 per cent return on his investments annually, whereas, Jim Simmons, founder of NewYork-based hedge fund Renaissance Technologies, has an annual return of 66 per cent. Based on just numbers, Simmons is technically the better investor.
But still, Warren Buffett’s net worth is $117 billion whereas Jim Simmon’s net worth is only $25.4 billion as of 2022.
How is this possible? The answer lies in the time period of investing.
Warren Buffett started investing in early 1940s. And Simmons started investing in 1988. This means, that despite higher returns on investment, Simmon’s wealth is no match for Buffet’s wealth.
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