The magic of compounding – Part II

the new tilt

Really understanding compounding will make all the difference in investing. I believe that Warren Buffett, the world’s largest investor, is programmed to think geometrically. He is rich beyond dreams because he totally grasps the magic of compounding and executes on the concept. I’m going to do these numbers wrong because I’m doing them from memory but it doesn’t matter. You will get the concept. Buffett started a partnership a long time ago. He had several limited partners invest with him and took 20% of the profits. In the late 1960s, he ended the association with his famous letter: “When you no longer understand the way the game is played, it’s time to quit the game.” I’m paraphrasing, even though it’s in quotes.

Buffet took about $100 million from that first partnership for himself, so he was working with $100 million, keep that in mind. In 1974, when the bear market bottomed out, it might have been early 1975, he started another rally… he took over Berkshire Hathaway. Buffett, since the 1970s, has had a compound (remember that means exponential) growth rate of about 22 to 24%.

This is where I introduce you to the bonus of the Magic of Compounding, which is called the Rule of 72. With the Rule of 72 you can calculate how long it will take you to double your money at any given rate of return. OK? Let’s take an example. If you are earning 12% of your money and you want to know how long it will take to double it (we are compounding, remember?) divide 72 by 12 and your answer is 6. It will take 6 years for your money to double. Let’s do another one. If you are receiving 6% of your money, divide 72 by 6 and you will see that it will take 12 years to double. If you get 9%, that’s 72 divided by 9, or 8 years to double.

As for Warren Buffett, he gets 22% of your money. This means he divides 72 by 22 and wow, in just 3.27 years, or every 3 years and 4 months, he doubles his money. Since he has spent 35 years with that $100 million he had to play with, he has doubled his original $100 million nearly nine times. You get it by taking 35 years and dividing by a double every 3 years and 4 months. It equals 10.70, or we go double nine to adjust for a varying compounding rate. The key point is that he is not making 9 times his money on the $100 million, that would be an arithmetic progression that would give him $900 million. He is doing nine doubles, a geometric or compound progression.

Let’s see how that works.

Warren Buffet’s geometric progression
Initial dollar amount: $100 million
Time periods involved: nine periods of 3 years and 4 months

Period Time spent Compound profit

0 Starting point $100,000,000

1 3 years, 4 months later $200,000,000

2 6 years, 8 months later $400,000,000

3 10 years later $800,000,000

4 13 years, 4 months later $1,600,000,000

5 16 years, 8 months later $3,200,000,000

6 20 years later $6,400,000,000

7 23 years, 4 months later $12,800,000,000

8 26 years, 8 months later $25,600,000,000

9 30 years later $51,200,000,000

I think Buffet is worth around $47 billion. Never mind, he’s somewhere in his ninth double. This is the magic of compounding! Also, it never sells. This means your money doubles every three years and four months with no tax consequences. You only pay tax when you sell. Under normal conditions, money is hoarded until you die, then taxed at a capital gains rate in the distant future. In Buffett’s case, he is handing over most of his wealth to the Gates Foundation to benefit society.

Teach your children to live a balanced life, and also help them master this concept and you will have very happy and very wealthy children. In stocks, I show you how to make money on the bottom by buying depressed stocks that are going to come right back, making you a fortune as they soar from the bottom. In the future I will also show you how to make money with the concept of Warren Buffet, or the classic analysis of Graham and Dodd. In the meantime, good luck with understanding the magic of compounding.

Start thinking exponentially, earn money now

Copyright 2006 Richard Stoyeck

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