Compounding is the “Interest on interest” and multiplies your capital at an accelerated rate the longer you leave it. Compound interest is calculated on the initial principal amount plus accumulated interest. Compounding works by retaining and reinvesting all interest without disrupting the process by drawing capital out.

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What is Compound interest?

Compound interest is a useful and relatively low-effort strategy for investors to achieve their financial goals over a long period of time. It involves reinvesting earnings from savings or investment funds to generate more earnings. The earnings on those earnings are also reinvested, and so on, leading to the phrase “Interests Interest”.

Although this strategy is simple, many investors find it hard to stick to it. They often disrupt the process or lack the patience to let their investments grow. Investing can be mundane, and many investors seek excitement and novelty.

Compounding is very powerful, don’t interrupt it.

Charlie munger

The process of compounding is quite straightforward. Investors simply add money regularly to a fund, leave it alone, and trust in the long-term growth of the market with all distributions reinvested to compound over a long enough time horizon. This approach may not seem like much, but compounding is the key to creating wealth. It requires patience, discipline, and the ability to manage one’s behaviour and not disrupt the process.

The power of compounding is a very important part of the investing game. It is hard for humans to think beyond a linear pattern. Trying to extrapolate returns well into the future becomes challenging.

The more time, the more growth potential.

The compounding explanation is usually associated with an illustration such as the above. We can see two different investors and different investing horizons. One invests earlier in life and the other starts later in life. The result produces an astonishing difference due to the power of compounding.

The higher your starting amount, the higher your investment return, and the earlier you start, the faster your savings compound. It seriously can add up over time.

Compounding Interest Vs Simple Interest.

There are two types of interest: Simple and Compound. Compound Interest is preferable when you want to earn interest on your savings or create wealth, such as on index funds, bonds, and term deposits. That’s because the interest you earn gets added to your principal, and you earn more interest on the new larger amount. Simple Interest, on the other hand, is suitable when you want to earn interest and withdraw it periodically, such as when you put $100,000 into a fixed-interest account.

Now, let’s say you leave the $100,000 in your account for 30 years. With Simple Interest, you would withdraw the interest every year. But with Compound Interest, the interest would get added to the principal each year, and you would earn interest on the interest. Let’s assume you earn an average of 10% annually, with NO contributions and just left it. The compounded interest would turn the starting capital into approx $1.745 million (Chart Below).

For borrowing money, Simple Interest is better. This is because you pay interest only on the original amount borrowed, not on the accumulated interest. If you were to borrow money and pay Compound Interest, you would end up paying much more interest over time.

Simple Interest is calculated based only on the principal amount, whereas Compound Interest is calculated on the principal amount and the accumulated interest of previous periods. Simple Interest is commonly used to calculate the interest charged on car loans and other forms of shorter-term consumer loans. Meanwhile, interest charged on credit card debt compounds, which is why it can grow so quickly.

In an ideal world, you would want your savings and investments to be calculated with Compound Interest, and your debts to be calculated with Simple Interest.

Time and Fees impact Compounding.

There is a reason why passive index investors are so popular – because it works! The creation of the ETF and the concept, as popularised by John Bogle, founder of Vanguard, is a great way to invest. I do not argue at all, and I also participate through my retirement fund with a low-cost index fund and a dollar-cost-averaging strategy.

You may wonder why I encourage passive index investing when I am an active stock picker writing about hunting down alpha. Well, why not? Taking advantage of the power of compounding in a tax-efficient and low-cost manner seems brilliant to me. You don’t need to reinvent the wheel to do well.

Time and fees play a significant role in the outcome of wealth creation, especially when considering how small variances can lead to vastly different outcomes. For example, if we engage a managed fund with a typical fee structure, as opposed to allocating our capital to an index fund and passively managing it ourselves, we can see a significant difference in the outcome.

If we assume that management fees are, say, 2.5%, as opposed to a 0.5% index fund, it may not seem like much. However, over a decade, assuming the initial capital allocation of $100,000 and both funds average a 10% annual return, the 2% variance due to fees eats away at total returns. Here is a simple example below.

Year	Managed Fund 2.5%	Index Fund 0.5%
Initial Capital	$100,000	$100,000
Contributions	$0	$0
Returns Generated	$106,103	$147,823
Total Compounded returns	$206,103	$247,823

The difference due to fees and the power of compounding leaves a $41,720 difference in returns over a 10 year time horizon. Nearly 20% off overall returns has been left out by only a 2% difference.

That is why Time, fees and returns matter down to the %.

The power of Compounding in Active Investing.

Compounding is a powerful strategy when it comes to buying and holding great companies over a long period of time. Allowing winners to run can lead to enormous returns, multibaggers!

However, compounding only works if it is not disrupted. This is where selecting high-quality companies comes in. It is important to pick the right companies and let them do the heavy lifting over time to achieve large returns. To do this, you need to constantly monitor the fundamentals of a company to ensure your thesis is still valid.

When selecting companies, look for ones that are compounding their capital at high rates of return. Although a company’s Return on Equity or Return on Capital may not necessarily correlate with what investors can expect to receive, shareholder returns will closely mirror them. This is why you should pick quality companies with strong competitive advantages that protect their higher returns on capital.

If a business has a long runway ahead and practices prudent capital allocation, then buying and holding these companies in combination with the power of compounding is where real wealth creation comes in. You can compound your capital tax-free (until you sell) and let quality companies create wealth for you.

Let’s look at a brief example of how two scenarios play out. Company A compounds capital at 6% annually. Company B with a strong competitive advantage compounds capital at 20% annually. Assuming we invest $50,000 to start with and leave our holdings for 15 years. Look at the significance of total returns.

	Company A	Company B
Initial Investment	$50,000	$50,000
Return on Capital	6%	20%
Holding Period	15 Years	15 Years
Estimated Returns	$119,828	$770,351

The difference is seven times in size. The power of compounding is most effective when applying it to quality companies.

Compound Interest Formula.

The formula for compounding interest is as below. I admit I have never in my life worked out compounding using the formula. I have my calculator (Compounding Calculator) so I’d much rather use this and save time. However, for those who like a little more intellectual stimulation, you can use the following formula.  

• A = final amount
• P = initial principal balance
• r = interest rate
• n = number of times interest applied per time period (Months, Years, Weeks.)
• t = number of time periods elapsed.

In Summary…

Compounding is a powerful tool for wealth creation that investors can use in various ways, such as holding fixed-interest accounts, passive investing through indexing, or investing in compounding companies. It is essential to understand the concept of compounding to make the most of it.

The reason why I am explaining this in Investment Philosophy is to help investors recognize the importance of compounding. By understanding how powerful it is, investors can shape their philosophy and strategy to look for those qualities during the investing process.

To make the most of compounding, you should have the conviction to hold your investments, monitor their fundamentals, and not get spooked out of the company due to market euphoria. Many investors have disrupted the power of compounding by being afraid and selling out of their investments. To avoid this mistake, take your cue from your thesis and the company’s performance, not market sentiment.

Compounding is not only applicable to wealth creation; it also applies to everything in life. You can compound knowledge, which is at the core of improving your investment skills over a lifetime of learning.

The most important factor when thinking about compounding is not to disrupt the process. Investors often make the mistake of not staying the course, even though they have a great strategy. I have heard many investors say, “Oh yeah, I used to hold that company, now it’s a multibagger.” But the most common reason why they sold out is that market fluctuations scared them. The fundamentals didn’t change; they just got spooked.

To make the most of compounding, you need to master your emotions, be patient, and not disrupt the process, whether it’s long-term contributions into a fund or finding the next mega-cap young! It’s about allowing compounding to do the heavy lifting for you.

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