The incredible power of compound returns

TL;DR: The human brain doesn’t grasp the power of compound returns intuitively. We weren’t built that way. It’s a problem because, today, we live in a compound world. Compound returns working for you will make you wealthy. Working against you, will leave you impoverished. Make sure you stay out of debt, and look for the right investments to get compound returns working in your favor, then just give it enough time for the medicine to do its work.

Compound interest is the 8th wonder of the world

– Albert Einstein

Our monkey brains aren’t designed to understand compound returns – this might have something to do with us living in a rather linear, non-compound world for most of our existence. Hunter gatherers didn’t really save or accumulate capital that would produce additional output for them. Saving half of that Elk you took down last week won’t produce an extra Elk a year from now… in fact, not only will it not produce another Elk, it will just rot. So perhaps that’s why we have so much trouble with compound returns – it’s just such a new concept for us, evolutionarily speaking.

This is a problem because we now live in a compound world. A world where savings today can be turned into productive capacity tomorrow. Capitalism is all about accumulating private capital and property, and employing it to produce more goods and services to enjoy.

Compound returns are everywhere. When you reinvest your dividends you are compounding your returns. When you roll investment property income into another property, you are compounding returns. When you let your capital gains ride by holding on to that Amazon stock, you’re compounding your returns. It’s great because each new dollar you generate instantly goes to work to help produce more precious dollars for you. It’s like having your own little army of workers.

Of course, compounding can work against you too, like when you hold credit card debt. Credit card debt compounds in the wrong direction – each dollar of debt starts breeding additional dollars of interest, and each of those new interest dollars start commanding an interest payment of their own. It’s like a terrible movie of Gremlins where they just keep multiplying.

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So either way, up or down, compound returns are a powerful thing. Almost magical. But don’t take my word for it, to illustrate I put together a little sheet that sheds light on the topic. Starting with one dollar, you can see the impact of compound returns over a 30 year period (typical mortgage) and 90 year period (average human life):

  • 1% is what you might get from government treasuries
  • 6% was the average bond return from 1926-2015 (90 years)
  • 10% was the average S&P 500 return over that same period
  • 14% represents pretty standard cash on cash returns (incl. mortgage pay-down) for investment property in the midwest
  • 18% is a pretty standard projected return for syndicated real estate investment deals

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View the source sheet here

Pretty wild, right? Yea, I’ve worked in business and finance my entire career, and I was still blown away when I sat down and did the math. I had to check and re-check the numbers to make sure the sheet was right. Armed with this information, it becomes a lot easier to understand how Warren Buffett has amassed such an incredible fortune in Berkshire Hathaway. Over the course of ~50 years (1965-2014 for this data), he averaged 21.7% returns:

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Source

Of course, it’s easy to run the numbers. It’s much harder to generate an average return of 21.7% over that timeframe. But the key is that he’s had more than 50 years to do it. When it comes to investing and wealth, time really is on our side. Make sure you stay out of credit card debt, and figure out how you can get compound returns working for you.

And remember – enjoy the journey!

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