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The Magic of Compounding

Some of you know about this, some of you don't. Either way I'm going to put radically different slants on this concept. As you read what follows, I want you to keep certain ideas in your mind. I also suggest you read the following not once, but several times. If you have children, print this and give it to them to read. If they master this, they’ll become rich. If they don't, it’s the difference between being the entrepreneur and the worker drawing a paycheck.

The first idea to remember is that computers are composed of both hardware and software. The software can be changed. The hardware is something you live with, until you're ready to throw it out and buy another computer. The analogy I want to use for a computer is a human being. The hardware is our bodies and our minds. What we have to start out with is what we live with. If you are destined to grow to be six feet tall, you are not going to change that and become seven feet tall. You live with it.

Our minds are both hardwired and soft wired. We can change the software. How we think about things, our prejudices, our attitudes, and our mind sets, this can all be changed and worked with. Certain things cannot be change. You either have a gift for mathematics and languages or you don't. Certainly, whatever level of gift you have can be augmented and worked with, but if you don't have Einstein's gift for math, that's just the way it is.

Now what does this have to do with the magic of compounding? And what is the magic of compounding by the way. The magic of compounding very simply is the difference between an arithmetic progression and a geometric progression.

The arithmetic progression goes like this: 2,4,6,8,10,12,14. The geometric progression or an exponential progression likes this: 2,4,16,32,64

The difference is everything in investing. When I am done, you will truly understand the magic of compounding, you will become a believer, and you will astound all your friends.

The reason why I talked about the computer analogy is because I believe as human beings we are hardwired in our brains. Our brains compel us to think about progressions as being simple arithmetic ones. An arithmetic progression is simple. You know 2,4,6,8,10, or 3,6,9,12,15. I also believe that Warren Buffet is hardwired to think geometrically. That is why he is the world's greatest investor.



So let's put it together. Now, I want you and your children to solve the following puzzle. What would you rather have someone give you; a million dollars, or a penny a day and the right to have that penny doubled every day for a month The answer appears at the end of this article under PUZZLE.

I'm assuming you looked at the answer. Amazing, is it not? This is why the wealthiest guy I know who is a member of the Forbes 400, has always told me," One of the dumbest things you can do with money is spend it." He puts everything into investments. Where he makes his mistake is he does not live a balanced life.

I have received e-mail from Oscar B. in Dayton, Ohio. Oscar must have several billion dollars in cash by now. He also drove a 20-year-old station wagon when I knew him. He could afford to buy 5% of General Motors and he's driving a 20-year-old station wagon. It shows how he values money.

At the same time, this behavior does not lead to a balanced life.

Have you ever noticed how mutual funds that have been around for decades tell you the following? If you had placed $10,000 with us in 1981, you would have $96,000 today. It's no big deal. It's the magic of compounding, not the magic of their thinking. Or they will say; assuming dividends and capital gains are reinvested. This is lunacy. People have to pay taxes; they can't pay taxes with capital gains. They have to pay taxes with cash. This is why mutual funds lie when they give you their returns. Every one of them assumes you reinvest the dividends and capital gains. Where are you supposed to get the cash from to pay your tax bill if not from the capital gains themselves, thus lessening your re-investment?

Now, back to Warren Buffet. He is the most successful investor in the world because he believes in the magic of compounding heart. He also executes on the concept. I am going to get these numbers wrong, but it doesn’t matter, you'll get the concept. I'm doing the numbers from memory. Buffet started a partnership way back when. He had a number of limited partners invest with him and he took a percentage of the gains. In the late 60s, early 1970's he terminated the partnership with his famous letter, "When you no longer understand the way the game is played, it's time to leave the game." I'm paraphrasing, even though it's in quotes.

In 1974, when the bear market bottomed, it might have been early 1975, he started another raise. Then came Berkshire Hathaway. Buffet took about $ 100 million out of that first partnership for himself. So he was working with $100 million, keep that in mind.

Do you know the rule of 72? If you don't you should memorize it. It's easy to work with. If you get a 12% return on your money and you want to know how long it will take your money to double, it's simple.

Take 72 and divide by 12. The answer is 6 years. If you get 6% on your money, it's 72 divided by 6 or 12 years. If you get 9 % on your money, it's 72 divided by 9 or 8 years. Buffet since the 1970's has been getting a compounded (remember that means exponential) growth rate of about 22 to 24%. That means 72 divided by 22 is 3.27 years, or he doubles his money every 3-years 4-months.

Since he's at it about 25 years with that hundred million he had to play with, that means he's doubled his original $100 million about seven times. Remember 25 years dividend by a double every 3 years and 4 months (25 divided by 3.4=7.69). Let's go with seven doubles.

Remember he's not making 7-times his money with the $100 million (that would be an arithmetic progression) he's making 7-doubles (a geometric or compounded progression).

Let's show the difference.

Warren Buffet's Geometric Progression Starting Dollar Amount: 100 million Time Periods Involved: 7 times (3-year 4-month periods)

Period Compounded (Exponential $)
0 starting point 100,000,000
1 - 3 years 4months later 200,000,000
2 - 6 years 8months later 400,000,000
3 - 10 years 8 months later 800,000,000
4 - 13 years 4 months later 1,600,000,000
5 - 16 years 8 months later 3,200,000,000
6 - 20 years later 6,400,000,000
7 - 23 years 4 months later 12,800,000,000

Buffet I believe is worth about $15 billion; it could be $20 billion at this point. It does not matter. He is somewhere in his eighth double. This is the magic of compounding.

You'll also notice he never sells. That means his money is doubling every 3-years 4- months with no tax consequences. He is taxed when he sells, only when he sells. The money compounds until he dies and then it's at a capital gain rate in the far, distant future. He could not sell if he wanted to. Emotionally, he can't bring himself to stop the compounding effect.

Teach your children this technique and you will have very rich children. In stocks I show you how to make money at the bottom, by buying depressed securities that are going to go right back, thus you make a fortune as they rocket off the bottom. In the future, I will also show you how to make money with the Warren Buffet concept or classical Graham and Dodd analysis. In the mean time, good luck with understanding the magic of compounding.

PUZZLE: Answer

On the one hand: On the other hand:
$ 1,000,000 Day Amount
1 $ .01
2 $ .02
3 $ .04
4 $ .08
5 $ .16
6 $ .32
7 $ .64
8 $ 1.28

Hey folks, it's day eight and I am up to $1.28. I only have a month; maybe I am better off by taking the one shot deal, a million dollars. Let's see what happens:

Day Amount Day Amount
9 $ 2.5610 $ 5.12
11 10.24 12 20.48
13 40.96 14 81.82
15 163.8416 327.68
17 655.36 18 1,310.72
19 2,621.44 20 5,242.88



Incidentally, did any of you ask what month of the year we're in? Is it February with 28 days, or leap year with 29 days, or September with 30 days, or October with 31 days? You should realize, it's going to make a difference. Do you want the million dollars, ask your kids by the way? Which would they choose?

Let's continue:
Day Amount
21 $ 10485.76
22 20,971.52
23 41,943.04
24 83,886.08
25 167,772.16
26 335,544.32
27 671,088.64
28 1,342,177.28
29 2,684,354.56
30 5,368,709.12
31 10,737,418.24

Leap year compounding wins, if I give you October with 30 days, you make over $5,000,000. With December, it's over $10,000,000. I have never met the child, who didn't leap for the $1,000,000 on day one.

This is because we think arithmetically, not exponentially. Start thinking exponentially, Make Money Now.

reprint permission from webtrading.com


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