Compounding Returns

COMPOUNDING RETURNS

A couple years ago, in his annual letter to shareholders, noted billionaire and philanthropist Warren Buffett, posed the following observation and question:  “Between December 31, 1899 and December 31, 1999…. the Dow rose from 66 to 11,497.  Guess what annual growth rate is required to produce this result.”

Over the one hundred year period Dow gained a remarkable 11,431 points.  But what kind of an annual growth rate is required to make this happen?  Remember that with compound returns, the growth each year is in effect added to the principle making it grow faster over time. 

When asked what he thought was the greatest mathematical discovery of all time, Albert Einstein supposedly replied “compounded interest.”  He went so far as to call compound interest The Eighth wonder of the World.  This is because over time, even very modest rates of annual return can produce very large numbers.  Most people tend to overestimate the annual growth rate when returns are compounded.

Several years ago, a farmer told me that he had just sold property for $2,000 an acre that he had acquired about 30 years earlier for just $350 an acre.  At the time he deemed this to be the best investment he had ever made.  While it may have been a good investment, the compounded returns required to grow $350 to $2,000 over a 30 year period is only about six percent.  This means that if he had purchased a $350 thirty year CD compounding at 6% a year, the end result would be over $2,000.

And the answer to Warren’s question:  the annual growth rate required to grow the Dow from 66 to 11,497 over a one hundred year period is 5.3%.  Of course investors would have also reaped the benefit of the dividends paid by these companies over the years as well. 

When speaking to groups about finances, I’ll sometimes convey the effect of compounding returns by asking this question:  If Columbus had invested $1 in a hypothetical bank, say Bank of the New World, when he first came to the Americas in 1492 at 5% simple interest (meaning the five cents earnings were withdrawn each year), he would have earned a total of $25.75.  But, if he had left the earnings alone and let that money compound, his balance today would be over $81,750,237,000, (that’s over 81 billion).

Although we don’t have 500 years, it is still surprising the results that a lifetime of prudent investing and saving can produce.

Written By Kimber Heaton CFP