The Miracle of Compound Interest | What a 26% Compound Interest Can Do

The 8th wonder of the world

Published on:
March 9, 2019
Reading time: 3 minutes.
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Page 3 of Sequoia Fund's annual report to shareholders demonstrates the power of compounding interest. Say it's now July 1970, you are 25 years of age and you place $10,000 in Sequoia. Fast forward to today, and your investment would now be worth $4.3 million at the end of last year.

Since its inception, Sequoia Fund achieved an annual rate of return of 13.65% compared to 11.00% for the SP 500 index - and this 13.65% yearly return compounded for almost 50 years would have turned a moderate amount of savings into a comfortable retirement.

The effects of compound interest

Can you imagine what a 26% compound rate of return could do? To illustrate the point, I will use $50,000 as a starting amount, which is what $10,000 was worth in the 1970s[1]. And using the 72-rule, we calculate that every three years, the initial amount will double.

So in 2022 it will be worth $100,000; in 2025 it will be $200,000; in 2028 it will be $400,000; in 2031 in will be $800,000; in 2034 it will be $1.26 million; in 2037 it will be $3.2 million; and in 2040 it will be $6.4 million. 

A compound rate of return of 26% over 21 years, multiplied the initial amount of by 128x.

And that is the miracle of compound interest.


How to achieve a high compounded interest 

To look for investments with a 26% rate of return means that you expect that the stock you buy today will be worth at least twice as much in three years. And to inspire for that level of return, you must be an active investor. 

I define an active investor as one who spends a large portion of the time reading and valuing companies, analyzing financial statements and corporate statements, and is not afraid to act completely different than the market. Active investing requires a lot of effort with an unknown expected outcome.  

Active investing requires a lot of effort in the present with an unknown expected outcome in the future.  

In pursuit of such high standards, the active investor will make a lot of errors. Both Mohnish Pabrai and Guy Spier bought Horsehead Holdings, a company that declared bankruptcy and wiped equity shareholders

Warren Buffett and Charlie Munger bought Dexter Shoes Company and Cort furniture, which Munger referred to as "macroeconomic error." And Sequoia Fund had a significant position in Valeant, a stock that dropped in price by 70% in 30 days two years ago.

By focusing on such a high, abnormal rate of return, we also avoid the stock of companies that cannot possibly demonstrate such a performance. For example, Nike Inc. earned $1.93 billion or $1.17 per share in 2018. For $69 per share, the implied earnings multiple is about 60 times. For the investor with a 26% required rate of return, the company would have to earn $3.86 billion or $2.34 earnings per share in three years, an unrealistic expectation [2]. 

Passive investing, defined as the purchase of ETFs, cannot return 26% either. The S&P 500 total return, which includes dividends reinvested, has returned an 11.66% over the past 40 years; the Dow Jones Industrial Average's with dividends reinvested annual return was 12.4% during that time. The Wilshire 5000 with dividend reinvested earned 8.7% during that time. 

And since the return of the stock market is dependent, in the long run, on corporate earnings, which have never shown to grow in the double digits, at 26% compounded return is unrealistic. 

Mohnish Pabrai

I learned about the rule of compound-at-26% from Mohnish Pabrai. In his talk at Boston College, he illustrates this point. The purpose of this meditation is by no means to convince you that a 26% rate of return is reasonable. The first point of this essay is to encourage you to think about an adequate rate of return for you and the second point is to reflect how you plan to achieve it.

FOOTNOTES 
[1] To be exact: $10,000 in 1970 is $63,175 in 2019. [2] Nike never grew earnings by that rate since it became a public company over 35 years ago.

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