Have you heard the story behind the invention of chess?
The inventor brought the chess board to the emperor of China, and the emperor was so impressed he said he would grant the inventor one wish. The inventor had the simple wish of receiving one grain of rice for the first square on the chess board, two grains for the second square, four grains for the third square, eight grains for the fourth square, and so forth. Sounding like a fair and modest proposal, the emperor agreed. However, it turns out that filling the last 10 squares on the chess board would have required 35 quintillion grains of rice – more than enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.
Who knows whether the story is true, but the point is that with compounding, grains seem small at first, modest in the middle, then suddenly overwhelming. In the investment world, what enables compounding? Time.
Let’s review the rule of 72. The rule of 72 states we can divide the number 72 by the rate of return we achieve, and the resulting number will tell you how many years it will take your money to double. For instance, if we obtain a 9% rate of return, it will take eight years (72 / 9) for our investment to double in value.
So what rate of return can we expect when we invest in the market? From 1920 thru 2014, the S&P 500 (a typical measure of the stock market) has returned an average annualized rate of return of 10.31%. Coincidentally, 72 divided by 10.31 equals 6.9835. Thus, if we had invested in the S&P 500 in 1920, our money would have doubled every 7 years.
What would happen if on the day your child, grandchild, or great grandchild was born, you invested $1 in the S&P 500 but kept it a secret. Assuming the infant lived to age 84, the dollar would be worth:
$2 at age 7
$4 at age 14
$8 at age 21
$16 at age 28
$32 at age 35
$64 at age 42 (still not a big deal, right?)
$128 at age 49
$256 at age 56
$512 at age 63
$1,024 at age 70
$2,048 at age 77
$4,096 at age 84
Over one life span, $1 grew into $4,096. Impressive! Now let’s add three zeros to all figures mentioned. In this scenario we invest $1,000, and after 84 years of the child’s life, you would have $4,096,000 in the investment account. Of course, I suppose you could invest $10,000 rather than $1,000…
The key, of course, is time. The child will have many urges to withdraw and spend the accumulated amount throughout his life. For this reason, the chances of success for this project likely increase if you can find a way to not tell the child for as long as possible.
How fun would this be? Imagine 84 years down the road, long after you are gone, the young heirs in your family line – who may have very ordinary finances at the time – suddenly get such a massive infusion of assets that they could then use to maintain the family’s stability for generations to come. All due to an amazing, mysterious great, great grandparent with the incredible financial foresight to take advantage of compounding. Now, imagine you stipulate that the heirs can have access to the funds only if they take a fourth of the resulting investment account and repeat the process!
Think of compound interest as a bunch of tiny personal employees that work extremely hard for you and mate like crazy!