There’s no shortage of ‘financial gurus’ trying to sell you new, innovative investment products these days. Spread betting, contracts for difference, options trading, Elliott waves. The list of products and systems that will supposedly increase your wealth overnight goes on and on.
However, if you’re serious about building long-term wealth, there’s really only one concept you need to understand and it’s rather simple. The concept I’m referring to is the power of compounding.
Buffett’s secret weapon
When motivational speaker Tony Robbins asked Warren Buffett what his secret to becoming the wealthiest man in the world was, Buffett smiled and replied: “Three things: Living in America for the great opportunities, having good genes so I lived a long time, and compound interest.”
And Buffett isn’t the only genius to have stressed the importance of compounding. Albert Einstein was also in on the act and was quoted as saying: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
If Buffett and Einstein give that much credence to the power of compound interest it’s probably worth taking note.
Compound interest isn’t a hard concept to grasp. Defined simply, it’s earning interest on your interest. Over time as you earn interest on your principal amount and on your interest, your wealth grows at a much faster rate than if you were just to earn interest on your principal.
For example, if £10,000 is invested for 30 years at 10% per annum using simple interest it will grow to £40,000. However if the same £10,000 is invested at 10% per annum using compound interest, it grows to a huge £174,494. And as time goes on, the disparity between the two portfolios gets larger and larger.
It really is a simple concept, yet what never ceases to amaze me is how many people fail to actually put the power of compounding into practice.
Low rate environment
Obviously, in today’s ultra-low rate environment it’s not as easy as it once was to put the power of compounding to work. No longer can you stroll into your bank, deposit your money and earn 6% per annum risk free.
These days, if you want to earn a half-decent return on your capital, it’s likely you’ll have to take on a degree of risk. And that’s where the share market comes in.
Long-term compounding machine
While the share market can be risky in the short term and your capital can fluctuate significantly, over the long term, it has proven to be an excellent compounding machine.
The key to compounding through the share market is to invest in high quality dividend paying stocks, that consistently increase their earnings and more importantly, consistently increase their dividends. Examples of such stocks include companies like Unilever, Diageo and British American Tobacco. Hold these kind of companies for the long term, reinvest the dividends and the power of compounding will be put to work.
If you’re hoping to get rich overnight you’ll be disappointed, but over the long term, your wealth will grow exponentially and in 30 years time, it’s likely your portfolio will be many, many times its size today.