IF I MADE A LIST of all the dumb things investors do, I likely committed them all. I chased performance, sold stocks in a bear market, invested in things I didn’t understand—you get the picture.
Yet, despite the numerous setbacks I suffered before I matured as an investor, I was able to retire comfortably. How was that possible? My conclusion: compound growth. Indeed, I believe compounding is a surer way to wealth than picking market-beating investments. That belief originated with, and was reinforced by, Warren Buffett.
The book Warren Buffett’s Ground Rules, written by Jeremy Miller, details lessons to be learned from Buffett’s annual letters to Berkshire Hathaway’s shareholders. The book’s second chapter is devoted to compounding. Here are three highlights from that chapter:
1. “The power of compounded interest is unmatched by any other factor in the production of wealth through investment,” says Buffett. “Compounding over a life-long investment program is your best strategy, bar none.”
The words “bar none” jumped out at me. Here is one of the world’s most astute investors saying that compounding trumps stock picking when it comes to building wealth over the long-term. That was an eye opener.
One of Warren Buffett’s favorite long-term holdings is Coca-Cola. He started purchasing shares in 1988. Today, it’s the fourth largest holding in Berkshire Hathaway’s portfolio. According to Buffett, “The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks.”
I’ve owned Vanguard Total Stock Market Index Fund (symbol: VTSAX) in my taxable account since 1998, and have reinvested distributions and purchased additional shares over the years. In 2022, this one investment yielded more than $13,000 in dividends. In the future, if I request that Vanguard direct those distributions to my money market fund, I’ll enjoy a nice boost to my retirement income courtesy of the U.S. stock market—and at the lower tax rate for qualified dividends.
When I think about my history with this fund, I realize that what was most important was the steady accumulation of dividend-paying shares, not a rising share price. Long-term investors might consider tracking the number of shares they own rather than the dollar value of their investment. An exponentially growing number of dividend-paying shares is what compounding looks like.
2. “Compounding derives its power from its parabolic nature; the longer it goes, the more impactful it becomes,” Buffett has written. “However, it does take significant amounts of time to build sufficient scale.”
We’ve all seen those graphs, with their upwardly sloping curves, that are used to illustrate compound growth. These graphs have three noteworthy characteristics. First, early returns have a modest impact and the power of compounding isn’t readily apparent. I often wonder if some people look at these early returns, conclude that compounding doesn’t work and then turn their attention to other investment strategies.
Second, the timeline in many of the graphs extends to 30 years or more. Patience is a virtue. Due to increased longevity, many recent retirees likely have two or three decades ahead of them. When trying to overcome the effects of inflation, compound growth can be as important to retirees as it is to younger investors.
Third, compound growth from reinvested dividends happens automatically and doesn’t require you to do anything. Compare this to the effort needed to choose individual stocks or do your own taxes.
3. “Small fractional changes in the compound rate produces hugely different outcomes over long periods,” notes Buffett. “Fees, taxes, and other forms of slippage can add up to have an enormous cumulative impact. While 1-2% a year in such costs seems minor when isolated to a given year, the power of compounding turns something that looks minor into something colossal.”
Consider an investor over a 30-year period earning a 5% average annual return after expenses, versus a pre-cost 7%. Missing out on those two percentage points yields a final result that’s half what it could have been.
Buffett states that, “Fees and taxes… have been crushing the long-term investment performance of most Americans.” He advises us to, “Avoid fees and taxes to the fullest extent practical.”
That’s why investing in low-cost, broad-based index funds is so appealing. But such investments must be bought and held. The more you trade, the more likely you’ll disrupt compounding and need to start over again, losing precious time.
Shlomo Benartzi, a professor at the University of California, Los Angeles, coined the term “exponential-growth bias” to describe people who are unaware of the effects of compound interest. He hypothesizes that such people think their savings grow linearly, not exponentially, and thus underestimate the benefits of long-term investing. Those with a linear mindset may conclude that it’s relatively easy to make up for lost time, and decide to postpone saving in favor of other, more immediate needs. But ask those trying to make up for lost time, and they’ll tell you that it’s far from easy.
Keep in mind that compound growth has a dark side. Inflation, the enemy of all investors, also increases exponentially. Each year’s inflation rate builds on last year’s rate. Aside from excessive debt, inflation is probably the biggest obstacle to wealth creation that investors face. We can use all the help we can get to earn positive real returns.
When trying to build wealth, compound growth is one of the few winds at our back. I’d like to see it emphasized far more frequently than it is currently. Too often, investment discussions seem skewed toward beating the market—and that’s a shame.
Philip Stein, currently retired, was a public health microbiologist and later a computer programmer in the aerospace industry. He maintains that he’s worked with bugs, in one form or another, his entire career. Phil and his wife Jeanne live in Las Vegas.