Compound interest is the most powerful concept in finance. If you understand it, you have a huge investing advantage over the long term. If you don't understand it, it can be a drag on your financial situation.
Compound interest works both ways. It can help you get rich, but it can also push your debts to unsustainable levels if you borrow more money than you can afford. Understanding this principle will help you build wealth while avoiding skyrocketing interest costs.
Buffett's key to wealth
Warren Buffett (Trades, Portfolio) has said in the past that compound interest is one of the three key factors that have helped him get where he is today. He once remarked, "My wealth has come from a combination of living in America, some lucky genes and compound interest."
If you know and understand how compound interest works, you can use this financial principle to help you build wealth with little work on your part.
For compound interest to work its magic, you have to make sure you don't lose money. That's why Buffett's first rule of investing is, "Don't lose money."
This is why most investors should buy a low-cost index tracker fund rather than try to pick stocks themselves.
The Oracle of Omaha has been highly successful at picking stocks throughout his career, but he is in a relatively small class. There are hundreds of thousands of investors around the world who have lost everything by picking the wrong stocks. Unfortunately, we hear almost exlusively about the winning investors who have been successful in creating giant fortunes for themselves.
The index portfolio
Some years ago, Buffett declared in an interview with CNBC that the investment strategy he recommended for his wife when he dies is putting 90% of the money into an S&P 500 index fund and the remainder in bonds to meet short-term cash obligations.
According to my calculations, a portfolio of this make-up would have achieved a compound annual growth rate of 11.6% over the past 10 years. The standard deviation of the portfolio over this time frame would have been 10.5% with a maximum drawdown at 14.2% and a Sharpe ratio of 1.05.
The investments I have used in this example are the low-cost Vanguard S&P 500 ETF (VOO) and Vanguard Total Bond Market ETF (NASDAQ:BND).
An average annual return of 11.6% would be enough to turn an initial investment of $10,000 in 2010 to $25,973 today.
Because the S&P 500 index has produced an average annual return in the region of 9% over the past 100 years, it is not unreasonable to say that these returns are a bit on the high side. But, they perfectly illustrate how powerful the effect of compound interest is over the long term.
The numbers above are based on an initial investment of $10,000. But what happens if an investor makes monthly contributions to this pot. According to my figures, an investor starting with a $10,000 investment and making monthly contributions of $200 over the nine years from 2010 to 2019, would end up with a total savings pot of $66,415 assuming a compound annual growth rate of 11.6% on the portfolio.
Beating the average
This is far above the rate of return investors actually receive. According to the annual DALBAR study, since 1988, the stock market's average return has been 10% per year. But stock fund investors have earned only 4.1% per year.
Overlaying this return figure on the contribution numbers above gives us a final balance of $40,613 for investors who have been managing their own investments without a tracker fund portfolio over the past nine years.
These numbers illustrate clearly why it would be better for most investors to own index funds, as well as the power of compound interest over the long term.
Disclosure: The author owns no share mentioned.
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This article first appeared on GuruFocus.