What was the first topic you learned in your introductory personal finance class? For many people, it’s the power of compound interest. Compounding, otherwise known as earning interest on previously earned interest, is one of the most powerful wealth building tools that has allowed even your average citizen to accumulate more wealth than “household names”.
Everyone is familiar with Warren Buffett and his incredible investment success over the years. Yet, what many don’t realize is that Buffett began investing at the age of 10, and $81.5 billion of his $84.5 billion net worth came after he turned 65 years old (Housel 49). The secret ingredient wasn’t day trading 24 hours a day, 365 days a year. Nor did he earn an absurd rate of return, though he did average 22% over his lifetime. He relied on a long-term outlook, compound interest, and a sustainable investment strategy. As Morgan Housel puts it in his book The Psychology of Money, “His skill is investing, but his secret is time” (Housel 50).
The word “sustainable” is often overlooked by young investors who attempt to beat short-term market returns by trying to find the newest, most profitable companies. While this strategy may work occasionally, it should not be relied upon over the long run and with a majority of investable assets. The power of compounding cannot be fully utilized if your investment strategy confronts volatility on a daily basis. The individuals who consistently contribute to their employer plans, IRA, Roth IRA, and other retirement and investment accounts without trying to beat the market generally outperform people who prefer short-term gains and day-trading (there are a few exceptions of course). It doesn’t take a rocket scientist or master's degree to invest intelligently, it takes a mindset. Two words that every investor must keep front and center when making investment decisions are sustainable and consistent.
Additionally, leveraging your portfolio with margin, while being a tremendous tool for increasing returns, can just as easily be turned into a double-edged sword and should not be relied on without the proper advice and guidance. A perfect example would be a market downturn and having to meet a maintenance margin requirement in your leveraged portfolio, while the “sustainable” investor is able to “buy the dip” with assets held in cash.
All in all, the power of time and compounding are two tremendously important nuances of investment success. The problem that most people encounter isn’t what the market is necessarily doing on a daily basis, it’s what is going on between their ears and general impatience to accumulate returns. Look back over the last 100 or so years and you will find that a sustainable, consistent investment philosophy will lead to success in the long run.
Housel, M. (2021). The psychology of money: Timeless lessons on wealth, greed, and happiness. Hampshire, Great Britain: Harriman House.