Compounding

ALBERT EINSTEIN DIDN’T say, “Compounding is the eighth wonder of the world.” But if he had, the praise would have been richly deserved.

As many investors are aware, investment compounding—coupled with heaps of time—is the leverage that can turn modest savings into huge sums. A simple example: If you invested $1,000 and earned 6% a year, you’d have $10,286 after 40 years. What if you invested $1,000 every year? After 40 years, your $40,000 total investment would grow to $164,048.

This assumes steady annual gains. What if you suffered large losses? It can badly derail compounding’s progress. Suppose you invest heavily in a few stocks that lose 75% of their value, turning your $1,000 into $250. To recoup that 75% loss and get back to $1,000, you’d need a 300% gain. Want to avoid such big losses? Your best defense is broad diversification.

While large investment losses are eye-catching, small, regular losses can be just as devastating, as the losses build on each other, creating brutal negative compounding. Inflation can decimate the spending power of a fixed income stream. Credit card interest charges can cost us dearly over the years. High investment costs and taxes can sharply slow compounding, so we amass far less than more cost-conscious, tax-efficient investors.

While compounding has long been a popular investment concept, it’s lately taken on a larger meaning. Folks will use “compounding” to refer to the cumulative benefit that comes from, say, studying a language every day, exercising regularly or continuously improving business methods. The notion: Small positive steps—repeated often—can produce extraordinary results.

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