Power of Compounding Interest

The 8th Wonder of the World

Published on:
March 9, 2019
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Page 3 of Sequoia Fund's annual report to shareholders shows the power of compounding interest. Say it's now July 15, 1970, you are 25 years of age and you allocate $10,000 in Sequoia. Fast forward to today and your initial $10,000 investment would have been worth $4.3 million at the end of last year. 

And all you would have had to do during those 47 years was to place a leap of faith in the fund's managers. Since 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% annual return compounded over almost 50 years 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 effect, I will use $50,000 as a starting amount (which is roughly what $10,000 was worth in forty years ago. To be exact: $10,000 in 1970 is $63,175 in 2019). And using the 72-rule, we see that every three years the initial amount will double.

So in 2022 it will be $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. Assuming a compound rate of return of 26% over a 21-year period, multiplied the initial amount of by 128x.

And that is the miracle of compound interest.

The three drivers for compound interest

Dividend yield, earnings growth and market sentiment drive market value. In market sentiment I refer to how eager will investors be to buy stocks. For example, as of 2018, investors are happy to buy the earnings of S&P 500 companies at 18 times the earnings; it was less than a decade ago that they paid less than 9 times the earnings.

How to achieve a high compound interest (also known as rate of return) 

To look for investments with a 26% required rate of return simply 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.    

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, what Munger referred to as "macroeconomic error." And Sequoia Fund had 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 return. For example, Nike Inc. earned $1.93 billion or $1.17 per share. At a price of $69 per share, the 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. Yet the company has never demonstrated that growth rate since it became a public company over 35 years ago.

Passive investing, defined as the purchase of ETFs, cannot return 26% either. The S&P 500 total return, which includes dividends reinvested, has return a 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 - brought 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, it is safe to say that 26% compound will not be seen.  

Mohnish Pabrai

I learned about the rule of compound at 26% from Mohnish Pabrai. Thanks to his talk at Boston College, I thought about why I am investing in stocks in the first place and what I am aiming to achieve. 

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.