Compound interest may not be Einstein’s eighth wonder, but it is a powerful tool for investors

R. B. Matthews and Doug McCutcheon

If you invest a sum of money at 10 per cent for five years, you will multiply your wealth by 1.6 times.

If you invest your capital at that rate for 10 times as long (50 years), you will not multiply your wealth by 16 times.

You will multiply it by more than 117 times.

Does this strike you as surprising? It should, because exponential growth (also known as compound growth) is difficult for the human mind to grasp.

Understanding it, however, is the wellspring of successful investing. Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Let’s go back to basics. Investing is simply putting a sum of money away for a period of time with a view to receiving back significantly more money, in real terms, in the future.

Your success as an investor is a function of two things:

  • your net investment return over time;
  • the length of time you remain invested.

What determines your long-term rate of return? Studies have shown that by far the most important factor is the asset class you invest in. Investing in a portfolio of growing businesses, through ownership of publicly traded or private companies, will produce the highest unleveraged return.

The only return that matters is your long-term return, and, for most asset classes, your long-term investment return is reasonably predictable. History teaches us that, over 20 or more years, assuming inflation is reasonably muted, your average annual return from investing in a portfolio of listed companies (stocks) is likely to be between 7 per cent and 10 per cent, before taxes.

Any tax paid on your investment return will, of course, reduce this. This is one of the few certainties in investing. Investors are taxed on their capital gains only when the asset is sold. There is, therefore, a huge advantage to holding each of your investments for the long run. As Warren Buffett has said, “Tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.”

Almost everyone focuses more on the rate of return than on the length of time for which their capital will be invested. However, to benefit from compound growth, it is essential to think about both factors – and your ability to change the investment time period is far greater than your ability to change the long-term rate of return. “Buy right and hold tight” is a slogan adopted by some of the world’s most successful investors.

This hold-for-the-long-run approach explains why almost all the world’s great family fortunes (think Buffett, Gates, Thomson) have been created by owning shares in a growing business over many decades, thereby allowing their value to compound over time on a before‐tax basis.

There is, however, a limitation on how long individuals can compound their wealth tax-free. On your death, you are, for tax purposes, deemed to have disposed of your investments. Consequently, your estate is taxed on your capital gains up to that date. So, for individual stockholders, buy and hold works best if you live to be as old as Methuselah.

Companies, however, do not suffer from mortality. If you own your investments through a company that you control through fixed value preferred shares, and set it up so the common shares are held by a trust for your children or grandchildren, you avoid paying capital gains tax on your death. A good tax accountant can help you with this.

The power of long-term compounding, and the fact that it is counterintuitive, are at the heart of why some investors become very wealthy over time – and most do not.