The magic of compound interest

There's not a lot you learn at school that has much relevance to investing. Mostly it's about developing a base of knowledge in any particular industry and then using some good old common sense—and these are things you pick up via books, chin-wagging down the pub and experience of the wide world rather than in any classroom. But there is one thing you should have learnt at school that's vitally important to investing, and that's compound interest.

Unfortunately, if your school was anything like mine, compound interest was dealt with towards the end of double maths on a Tuesday morning in springtime. With the drone of the mower out on the sports field and the sweet smell of freshly cut grass drifting in through the window, Mr Smallbone launched himself on the subject in his usual measured tones and very soon … ZZZZZZZZ …

If this sounds at least a little familiar, and you haven't since filled the gap, then this article is for you. First of all, let's take a glimpse at the magic of compound interest at work. Back in 1967, two sisters in their late teens, Gay and Prudence (whose research featured in our cover story to issue 195/Mar 06, titled Prudence says no to infrastructure), each inherited $1,000 worth of shares in Cash Cow Corporation. Over the years, Cash Cow stock has risen at a steady 7% a year, but it has paid a further 8% each year in dividends.

High life

Now Gay has always lived what she herself calls the ‘high life', and she's always needed her Cash Cow dividends to help fund it. Still, her holding is now worth $14,974 and this year's dividend of $1,198 will buy a good few bottles of bubbly. Prudence, on the other hand, has always been more restrained. That's not to say she hasn't had a good time, but her nights out have been less extravagant and they've always been paid for out of her income as a dance teacher.

So Prudence's Cash Cow dividends have always been reinvested via the company's dividend reinvestment plan (see DRPs - the money or the shares? for more about these). But with her legs beginning to creak a little on the dance floor and with husband Walter considering retirement, Prudence is thinking she might just start paying the dividends into her bank account. This year she'll get—abracadabra—$21,429, from a shareholding worth $267,864. And that, ladies and gentlemen, is the magic of compound interest.

But as we all know, there's no such thing as magic. Just as David Copperfield makes elephants (seem to) disappear with the clever use of mirrors, compound interest wields its incredible power through the simple mechanism of multiplication. It's just that when you keep multiplying year after year, without taking anything out, then you multiply the bits you've already multiplied and after a while it really starts to mount up.

In Prudence's first year, for example, her shareholding grew by 15% of the original $1,000 (including the reinvested dividend)—or $150, leaving her with $1,150. But in the second year, she made 15% on the original $1,000 again, that is $150, plus 15% on the $150 she had made in the first year, or $22.50—a total increase of $172.50, leaving her with $1,322.50. And in the third year, she made 15% on the original $1,000, 15% on the first year's $150, 15% on the second year's $150 and 15% on the second year's $22.50—a total of $198.38, to leave her with $1,520.88.

Rule of thumb

The way it works out, Prudence's holding doubles about every 5 years, so by the time 40 years are up, it's doubled about 8 times. Gay's holding, on the other hand, takes around 10 years to double, so she only manages to double 4 times in 40 years. A handy rule of thumb, called the ‘rule of 72', is that you can get the number of years for a doubling by dividing 72 by your growth rate.

So the real power of compound interest works when you keep going steadily upwards, year after year, without taking a backwards step. If Prudence had made a 15% loss instead of a 15% profit every tenth year (that is, 4 years out of the 40), then she'd have ended up with just $79,946 and would have been better to have settled for a steady 12% (which would have given her $93,051).

Note also how a small difference in your growth rate can make a huge difference over the years. If Prudence, for example, had paid an investment adviser 1.5% a year to advise on her Cash Cow holding, so that it increased at only 13.5% (15% minus 1.5%), the holding would now be worth only $158,429. No wonder so many people do their own investing. Yet many private investors trade too much, slowing themselves down by leaking several per cent each year in brokerage costs.

Loan from the tax man

Overtrading will also slow you down because you have to give a slice of your return to the tax man each time you sell for a profit. Yet if you just sit tight, the money you would have paid in tax remains in your portfolio earning more money. It's as if the ATO gives you an interest-free loan—and that's about the best you'll ever get out of it.

All this goes a long way to explaining Intelligent Investor's approach to investment. Our conservative style won't double your money in any one year, but it shouldn't see us taking too many backwards steps. And our long-term approach keeps trading costs low and makes good use of our loan from the tax man. We admit it can be a bit dull at times, but we'd rather have the magic of compound interest working for us rather than against us.