The Joys of Compounding

In the context of investing compounding can be considered an anti-dote to the problem of inflation discussed in previous post. Compounding is the exponential growth in the value of ones investments as a result of reinvesting the proceeds from the original investment. The reinvestment can be either explicit (e.g. reinvesting the stock dividends or coupon/interest payments on a bond) or it can be implicit (e.g. reinvestment of retained earnings by companies in case of stocks or a zero coupon bond). If the investments are compounded at a decent rate of return, its value can grow significantly over time. Let me give you a couple of examples to consolidate this point. These examples were quoted by one of the best known compounders of money (yes, its Warren Buffett!) to his investors in the 1960s. I am merely extrapolating the numbers to the present time.

1. In the year 1492 the Spanish queen Isabella underwrote Christoper Columbus' voyage which led to the discovery of the americas for a sum of $30,000. As we all know that was indeed a blockbuster finding and it brought incredible riches to the Spanish empire . Lets suppose the queen had followed a low key approach of investing that same money at the rate of 4% compounded annually. The money today would have grown to about $18.5 trillion (compare this to the current US GDP of $14 trillion, US Stock Market Cap of $12.5 trillion & Spain's GDP of $1.6 trillion)
2. In 1540, Francis I of France paid 4,000 ecus (equivalent to $20,000 at that time) for Leonardo da Vinci's painting Mona Lisa. We all know that even after 5 centuries it ranks among the most famous paintings of all time. Lets suppose Francis had invested the same amount at a conservative rate of 4% compounded annually. The money today would have grown to $1.87 trillion. While I not an expert at appraising artworks, I guess that money can easily buy you all the paintings of all the famous artists you may have ever heard off.

The key lesson to learn here is that with a decent rate of compounding one can grow their savings to an incredibly bigger amount over a sufficiently long period of time. A reasonably successful investor does not necessarily have to hit a jackpot like finding a new continent or have the foresight to buy a painting like Mona Lisa before it comes wildly popular.
I think there is another key take-away from this example, an average investor should not have an unreasonable expectation of earning a very high rate of return (> 15-20% per annum) over longer periods of time (i.e. 10+ years). I will address that issue in my next post 'Sensex at 29,24,100'.