Compounding - The real key to wealth

"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it" 

--Albert Einstein


Another day and another conversation between Grandpa and his Grandson.


Grandson: Grandpa, how did you get to retire so early? You must have been a genius with money!


Grandpa: Well son, I was very fortunate to have a wise teacher when I was young who taught me the secrets to building wealth over many years.

It all comes down to living simply, saving diligently, investing those savings patiently, and letting compounding work its magic.

Grandson: Compounding? What's that?

Grandpa: Compounding is like a multiplying trick for your money! Here's how it works - when you invest your savings, you earn interest or dividends on that money. But here's the cool part - if you leave that interest and dividends invested instead of spending it, then the next year you start earning MORE interest on top of that!

Grandson: So it's like earning interest on your interest? Woah!

Grandpa: Exactly, it's interest on interest! And the longer you leave it invested, the faster that compounding makes your money grow. In fact, there's a handy "Rule of 72" that tells you how long it takes for your money to double based on the interest rate.

[Note: It was first articulated by Italian mathematician Luca Pacioli in 15th century AD.]

Grandson: How does that rule work?

Grandpa: It's simple - you just divide 72 by the annual interest rate you're earning. So if your investments earn 6% per year, 72 divided by 6 is 12. That means at 6% interest, your money will double every 12 years!

Grandson: Every 12 years?? That's incredible! I want to be rich too. Can you give me an example of someone who got wealthy this way?

Grandpa: Absolutely, there was a humble man named Ronald Read who worked as a janitor and later as a gas station attendant in Vermont. But by living frugally, saving diligently, and investing wisely over his lifetime, he had accumulated nearly $8 million by the time he passed away!

Grandson: $8 million?? For a janitor?? How on earth did he do that?

Grandpa: Ronald lived an extremely modest life and avoided excessive spending. Whenever he had even a little bit of money left over, he saved it up and invested it, primarily in stocks of good quality companies that paid dividends.

Grandson: Dividends?

Grandpa: Yes, dividends are the portions of a company's profits that get paid out to the stockholders. Whenever Ronald received a dividend from his stock investments, he didn't spend it - he immediately reinvested it to buy more shares of that stock. This allowed him to take full advantage of compounding.

Grandson: I think I'm understanding... So he kept putting his money back into more investments over and over again?

Grandpa: Precisely! By reinvesting all of those dividends to purchase additional shares, his investments grew even more over time through compounding. This strategy of buying shares of dividend-paying companies and continually reinvesting the payouts is an incredibly powerful way to build wealth.

Grandson: Wow, that's brilliant! But Grandpa, don't rich people like Ronald already start off with tons of money to invest?

Grandpa: Not at all! In fact, starting as young as possible with whatever modest amount you can is the real key. Let me tell you about Warren Buffett, who grew up in a regular middle-class family. When he was around your age, he used the $120 he had managed to save up from doing odd jobs and delivering newspapers to purchase his very first shares of stock!

Grandson: No way! And now he's like, a multi-billionaire?!

Grandpa: You got it. By starting his investing journey at such a young age and continuing to reinvest his profits over a span of many decades, compounding turned that initial $120 into a tremendous fortune over time. His small beginnings show that anyone can build wealth gradually through disciplined saving and investing.

Grandson: I definitely want to be like Warren Buffett when I grow up! This compounding thing is so cool. Thanks for explaining it all, Grandpa!

Grandpa: You're very welcome, son. The sooner you start, the more compounding can work in your favor. Just make a habit of living frugally, paying yourself first by consistently investing, and being patient. Over many years, even small amounts can blossom into an incredible nest egg.


Grandson: You mentioned how Warren Buffett started investing at my age with just $120. That's amazing he became so wealthy! Can you tell me more about how his wealth grew over the years?

Grandpa: Absolutely. Warren Buffett's journey really highlights the long-term power of compounding. At age 11 when he bought those first shares, his investment was tiny. But by age 30 in 1960, his net worth had already grown to around $1 million through his partnership and investments.

Grandson: Wow, a millionaire by 30!

Grandpa: Yes, and it just continued compounding from there. By age 35 in 1965, when he took control of Berkshire Hathaway, his net worth was already $26 million. At 50 years old in 1980, it had reached $140 million as Berkshire expanded.

Grandson: This is getting crazy! How much more could it possibly grow?

Grandpa: Just wait - by age 60 in 1990, Warren Buffett's net worth crossed $3.8 billion. Ten years later at 70, it was an incredible $36 billion after a boom decade for Berkshire's stock.

At 80 years old in 2010, his net worth hit $47 billion. Can you believe that? And finally, by age 90 in 2020 he was worth a staggering $73 billion! As of just last year at 93, Warren Buffett's net worth was estimated around $117 billion.

Grandson: *mind blown* I can't even comprehend numbers that big! From just $120 as a kid?

Grandpa: Exactly, all thanks to compounding over decades upon decades. His money multiplied exponentially by leaving his investments untouched and reinvesting the gains over his lifetime. It's a perfect example of starting early and being patient.



Grandson: I definitely want to be like Warren Buffett when I grow up. Starting early is the key then.
Also not interrupting the compounding process
I got it Grandpa.

Grandpa Speaking of starting let us walk through an example comparing two people who invested the same amount, but one started early and onestarting late.

Imagine we have Anna who starts investing at age 20, and Ben who doesn't start until age 30. But they both invest $1,000 per year and earn 7% annual interest.

Anna gets to take advantage of investing for 40 years from 20 to 60, while Ben only invests for 30 years from 30 to 60. Each year Anna invests, that money has more time to compound compared to Ben starting 10 years later.

So by the time they're both 60 and stop investing, Anna's total wealth will have compounded to approximately $227,490. But Ben, who started later at 30, will only have around $99,540 at 60.

Grandson: Whoa, starting just 10 years later cut Ben's wealth by more than half vs Anna!

Grandpa: Precisely. With the same inputs, just by investing for an extra decade in her 20s, Anna ends up with over double what Ben has at age 60. It's a crystal clear example of the massive advantage of starting as early as possible.

Grandson: You're absolutely right, Grandpa. I'm going to start saving and investing as much as I can right now! Even if it's small amounts, I want that compounding to start working for me early. This has been such an eye-opening lesson. Love you Grandpa.


[Note: These ideas are better presented by the masters in their books.  I tried to present them per my understanding]



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