THE POWER OF COMPOUNDING IN INVESTMENT
The Power of Compounding: The Greatest Wonder of Investing
How a 1% improvement to your average return can multi-fold your investment value in the long term
Greatest investors often emphasize the magical effects of compounding on growing your wealth over time.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest” — Warren Buffett
Albert Einstein even called it the 8th wonder of the world:
“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” — Albert Einstein
The Power of Compounding
In the 94-year period from 1928 to 2021, the S&P 500 Index had an average annual price return of 7.97% (note: this is not CAGR, but a simple average).
With this average return, the S&P 500 — which was at 17.66 at the end of 1927 — ended 2021 at 4,766. (CAGR of 6.14%).
This is what you could have achieve with a 100% passive investment in the S&P 500 Index.
But with even a very small improvement to your average return, the power of compounding will do its magic to immensely grow your wealth in multi-folds over the long term.
In fact, if you could have improved only the negative return years by just 10% (in other words, if you were able to get -34.64% vs. -38.49% in 2008, and do this for all the years with negative returns — which were only 29 out of 94 years, or less than 1/3 of the whole period), the 94-year average return would be improved to 8.42% (vs. 7.97%).
This seems to be such a small improvement, but due to the power of compouding, the long-term improvement on your investment value is substantial. With 8.42% average return over 94 years, the S&P 500 would have been at 8,391 at the end of 2021 (vs. 4,766 with 7.97% average return). (CAGR of 6.78%).
With a 20% improvment for only the negative years, the average return would improve to 8.87%, still only 0.9% point better than the actual average return of 7.97%, but with this improvement, the S&P 500 would have been at 14,464 by the end of 2021. (CAGR of 7.40%).
Finally, let’s take a look at the total return (which takes into account the dividend returns) which, over the 94-year period had an average return of 12.07% — just 4% point more than the price return average of 7.97%.
End of 2021 value?
161,873. (CAGR of 10.19%).
That is the power of compounding.
