In March 2023, American investor Warren Buffett was ranked in the fifth spot on the Forbes list of the world’s wealthiest individuals, just one spot below Microsoft cofounder Bill Gates. What is interesting to note about Buffett’s net worth, which jumped from $82 billion in September 2020 to more than $180 billion in 2023, is that a considerable percentage thereof boils down to a simple investing strategy that is just one step above a savings account in terms of complexity.
Compound interest is the strategy by which Buffett has been able to grow his wealth exponentially by more than 7,300% since he was a teenager, but it was not his first strategy. Buffett became a stock investor at the age of 11 when he purchased shares of a company named Cities Service, so he was into equity securities before he started compounding. When he started generating income from delivering newspapers as a high school student, he opened a savings account in a local bank, and he explicitly requested compound interest as a feature. From this point on, Buffett stuck to a disciplined regime of making frequent deposits to his compound interest account; he also adhered to a sensible budget to maximize his disposable income, which he immediately turned into a savings account deposit.
Buffett knew that compounding served two purposes simultaneously. The first one was a solid financial foundation in terms of budgeting and saving. The other was a financial math logarithm that can be more easily understood with the following formula:
A = P (1+r/n) nt
The goal of compound interest is to reach the final amount represented by “A” above. “P” stands for the principal or initial balance of the account. The compounding interest feature has “r” for the rate of interest (usually annual percentage yield), “n” for how many times the interest rate is paid into the account, and “t” is how long the account is open. It is important to note that the savings account feature known as simple interest does not offer exponential growth even if banks offer a higher rate. With a compound interest strategy, you can save and build wealth; with simple interest, the wealth-building aspect is diminished to the point of not being practical.
There is more than just math involved when compounding is used as a strategy for investing. The aforementioned financial foundation that Buffett built during his high school years is perhaps more important than the exponential nature of compound interest, and we will discuss this in greater detail later.
Compound Interest as a Financial Way of Life
Investing is how financial institutions earn enough money to extend credit to their borrowers. At its most basic level, investing can be broken into the following methods:
* Trading
* Speculation
* Arbitrage
* Value investing
Of these four methods, the first three are usually practiced by investors who chase short-term gains. Value investing is what Buffett has done his entire life, and it can be described as a “get rich slowly” strategy. We are talking about an investor who started with an investment of less than $150 during World War II, and who took 48 years to make his first billion dollars. This is the first thing that should be understood about value investing and compound interest: It takes time for the strategy to generate impressive gains, and the only way to accelerate it is to increase deposit amounts.
To evaluate a realistic example of compound interest, let’s assume you have $1,000 on hand to get started in March 2023. A high-yield savings account at Capital One in the United States pays an annual percentage yield (APY) of 0.30% compounded every month. Using an online calculator for compounding, we can see that in 10 years you will have $1030.45 if you just let the money sit. Since the power of compounding is fueled by deposits, let’s say you can deposit $500 each month religiously; by March 2023, your account will grow to $61.932.
If you can set your sights higher and commit to depositing $1,000 per month into your Capitol One account, you will have $122,833.13. Since this is simple math, it is easy to understand that the exponential growth comes from the bank applying the accrued interest on the rolling account balance instead of the initial deposit. Simple interest does not work this way, and neither do stocks nor conventional bonds, or many other investments.
The reason compound interest works better as a financial way of life is that you are not limited to depositing disposable income. Buffett has deposited just about every penny he has been able to save, and this includes the sizable profits from the Berkshire Hathaway portfolio of investments. If Buffett were to win a few hundred dollars playing bingo or scratch lottery tickets, he would likely deposit them in his compound interest accounts where they can make his balance larger, thus increasing his growth potential.
Evaluating Compound Interest Investments
When it comes to compounding, you are hardly limited to high-yield savings accounts. Inflation-protected bonds (I-Bonds) from the United States Treasury, for example, have a compound interest feature that pays twice a year. Certificates of deposit offer this feature as well, and their rates tend to be higher, but you have to be on top of their maturity dates so that you know when the time comes to shop for other CD opportunities.
Money market accounts also pay compound interest, but their rates tend to be lower because of the higher flexibility of the account as such. Quite a few 401(k) plans and mutual funds will compound at market rates; this can be found on the prospectus to investors. There are even real estate investment trusts (REIT) that pay compounded APYs, and some of them can be obtained and traded as if they were stocks.
In the end, the magic of compound interest is closely tied to how much and how often you can contribute to the portfolio. Needless to say, this strategy works better if you start in your younger years, but many investors who are in their 50s set a 10-year financial horizon so that they will have a nice cushion before they begin receiving their pensions.
