Albert Einstein once called compound interest the “eighth wonder of the world.” He famously said, “He who understands it, earns it; he who doesn’t, pays it.”
That simple yet profound statement holds a powerful truth about building wealth – understanding and leveraging the concept of compounding can create extraordinary results over time.
Whether you’re a small business owner planning for growth, an entrepreneur seeking to lower your tax burden while building wealth, or just someone saving for retirement, compounding is a financial tool that can work wonders.
Let’s explore what makes compounding so powerful and how you can use it to supercharge your savings.
A Brief History of Compounding
The principle of compounding is not new. It has been a cornerstone of financial growth for centuries. Historical records suggest that the concept originated with early trade and banking systems, where lenders would reinvest interest earnings to increase wealth.
Fast forward to modern times, and compounding has become the backbone of investment strategies used by financial giants like Warren Buffett, nicknamed the Oracle of Omaha, who attributes much of his extraordinary success to this principle.
Buffett began investing in his teens, and his fortune grew exponentially over decades because he understood the magic of compounding. The longer he kept his money invested, the more significant his returns became. This underscores an essential rule of compounding: time is your greatest ally.
The Mechanics of Compounding: A Simple Example
To grasp the magic of compounding, imagine you invest $10,000 in a savings account that offers a 5% annual return. After one year, your investment grows to $10,500. In the second year, you don’t just earn 5% on the original $10,000 but on $10,500. By the third year, you’re earning interest on $11,025. Over time, the growth accelerates, creating a snowball effect.
Compare this to a scenario where you withdraw your interest every year instead of reinvesting it.
While your initial $10,000 would still earn 5% annually, the total growth would pale in comparison to the compounding effect. Below is a boring graph to illustrate…
Quick Note: this graph isn’t entirely accurate. Can you spot the issue? If you’re withdrawing the interest each year, your initial $10,000 should stay exactly that… $10,000. I did this on purpose, let me explain.
But here’s where many people get tripped up: they assume they can invest, withdraw the earnings, and still watch their account grow. In reality, after 30 years, the balance would still be $10,000. So, that “red” line? It’s more of an illustration than a true reflection of how an account would behave. Just making sure you’re actually reading this and not just admiring the visuals!
Now… imagine if you each year added an additional $10,000 to the principal amount that would earn interest each year. Add time and discipline to this investment philosophy and you’ll be living life during your retirement years. With this concept, the further down the X-axis you travel… the “hockey stick” just gets more drastic.
Simple Example: The Power of Reinvestment
Let’s consider two friends, Sarah and Alex. Both invest $10,000 at a 7% annual return. Sarah reinvests her earnings, allowing them to compound, while Alex withdraws his returns each year. After 20 years, Sarah’s account grows to over $38,000, while Alex’s investment totals $10,000… his original investment.
To be fair, we should remember that Alex does have an additional $700 each year to spend at his discretion. In my eyes, Sarah is the clear winner in this scenario and the difference lies in Sarah’s decision to let her earnings work for her.
This example highlights a crucial point: compounding isn’t just about earning interest; it’s about earning interest on your interest. The reinvestment of dividends, returns, or profits accelerates growth in ways that are almost impossible to achieve through simple interest alone.
Supercharging Your Savings: The Power of Additional Contributions
Compounding interest is powerful on its own, but you can amplify its effects by adding extra contributions to your principal each year. Think of this as giving your investment an annual “booster shot.” When you contribute additional funds, you’re not just earning interest on your original investment and reinvested interest – you’re also growing the base amount that compounds over time. For example, let’s revisit Sarah, who invested $10,000 at a 7% annual return.
If she adds $2,000 to her principal every year, her account grows to roughly $120,000 after 20 years. That’s more than triple what she’d achieve by simply relying on compounding alone. By consistently increasing the principal, you significantly accelerate the growth of your savings, creating a financial snowball effect that can help you achieve your goals faster.
This strategy works especially well for business owners who can allocate portions of increased profits or cost savings directly into their investment accounts.
Warren Buffett’s Compounding Success
Warren Buffett often calls compounding the cornerstone of his wealth-building strategy. His approach is simple: invest in high-quality assets, let time work its magic, and resist the temptation to withdraw too soon.
Berkshire Hathaway is a prime example of this philosophy in action. By reinvesting profits instead of paying dividends, the company has steadily multiplied its value, turning it into one of the most successful enterprises in history. This internal compounding effect is what fuels Berkshire’s long-term growth.
I have no doubt Buffett would read this and nod in approval. But he’d likely add a key piece of advice: for most investors, the smartest move is to buy a low-cost S&P 500 index fund that reinvests dividends. His reasoning? Betting on the long-term success of the American economy (and staying disciplined) is the best strategy for the average person.
If you’ve ever listened to Buffett speak at Berkshire’s annual meeting, you’ve probably heard his thoughts on picking individual stocks. He believes in choosing great businesses within industries you understand, that outperforms its competition, led by strong management teams, with a track record of predictable growth and balance sheet with a low amount of debt. In other words – a true compounder.
For individuals and small business owners, the lesson is clear. Whether you’re investing in the stock market, reinvesting business profits, or saving for retirement, the secret to compounding is consistency and patience. Stay the course, and let time do the heavy lifting.
Harnessing Compounding for Your Savings
If you’re saving for an investment or building a retirement nest egg, the key to leveraging compounding is to start early, stay consistent, and reinvest your earnings.
- Start Early: The earlier you begin investing, the more time your money has to grow. Even small contributions made consistently over decades can yield impressive results.
- Be Consistent: Regular contributions, even during market downturns, ensure that your investment continues to grow steadily.
- Reinvest Dividends: Many investment platforms allow you to automatically reinvest dividends, turning passive earnings into active growth.
- Stay Disciplined: Resist the urge to withdraw your earnings prematurely. Time and patience are critical to maximizing compounding’s potential.
Just to throw out an idea from my Tax-Planner’s point of view: imagine the power of compounding when utilizing your ROTH account to it’s full potential. As you add interest and additional principal to the account… and you never have to pay taxes on these funds ever again – isn’t this the slam dunk every retiree should focus on? As always, take this for what it’s worth… just my personal and humble opinion.
Practical Applications for Business Owners
Business owners can use compounding not only in personal savings but also in their business strategies. For example:
- Reinvesting Profits: Instead of taking large distributions, reinvest a portion of your earnings back into the business. This can fund growth initiatives, reduce debt, and ultimately increase profitability.
- Tax-Advantaged Accounts: Take advantage of retirement accounts like IRAs or 401(k)s, which allow you to defer taxes and maximize compound growth.
- Employee Incentives: Consider offering employees profit-sharing plans or stock options that compound over time, aligning their success with the company’s growth.
It’s important for all business owners to closely evaluate what to do with their potential profits. I see too many entrepreneurs being short sighted and putting money into retirement accounts yielding 9-12% yearly… while putting that same money into their business that could yield 25-30% on a yearly basis.
Although I am a huge proponent of saving for retirement, all I’m trying to get across here is that maybe there is a more optimal way of splitting your profits to benefit both avenues of growth.
The Takeaway
Compounding is more than a mathematical concept; it’s a mindset. It requires patience, discipline, and a long-term perspective. Whether you’re growing a business, saving for retirement, or simply building wealth, the principles of compounding can transform your financial future.
Once you are ready to take the next step in your financial journey.. book a free consultation and we will explore a tailored path for you and your situation.
Welcome to the New Age of Accounting. Let’s begin.
Chris is the Managing Partner at Weston Tax Associates, a best-selling author, and a renowned tax strategist. With over 20 years of expertise in tax and corporate finance, he simplifies complex tax concepts into actionable strategies that drive business growth. Originally from Sweden, he now lives in Florida with his wife and two sons.
