Albert Einstein has been credited with a few powerful quotes on compounding interest. Whether he said them or not is up for debate. The first quote is, “compounding [interest] is the most powerful force in the universe.” The second quote is, “compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Warren Buffett’s right hand man Charlie Munger, said that understanding both the power of compound interest and the difficulty of getting it, is the heart and soul of understanding a lot of things.
Compound Interest will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. Time is your best friend and the one thing that makes compound interest so effective. Warren Buffett recently spoke at an event commemorating the 100th anniversary of Forbes magazine. He said that “being short America has been a loser’s game. I predict to you it will continue to be a loser’s game,” He predicted that the Dow Jones Industrial Average will be “over 1 million” in 100 years. The legendary investor thinks that anyone betting against America is “out of their mind.” This optimist prediction of Dow 1 million isn’t even that bullish. Mario Gabelli, joked on Twitter, “one million in one hundred years … has Buffett turned bearish?”
For the Dow to reach the 1 million level, the compound annual return would only need to be 3.87%. The Dow has returned 5.7% annually over the past 100 years and 9.3% annually since 1980. Benjamin Franklin would also disagree with Warren Buffett’s bearish 1 million level in 100 years. Franklin’s magic number would be closer to 5%. How do we know this? When Franklin died in 1790, he left the equivalent of $4,400 each to the cities of Boston and Philadelphia in his will. His instructions were that a portion of the funds could be used after 100 years and they would receive the remaining funds after 200 years. When the cities received their balances after 200 years, the combined bequest had grown to $6.5 million. Had the cities followed through with Franklin’s exact instructions, the combined amount would be $40,000,000 at the end of 200 years. Boston’s fund grew to $5,000,000, while Philadelphia only had about $2,000,000. Franklin had estimated the number to be closer to $36,000,000. Franklin’s mistake was leaving the money to the government and not to an investment company. We should give Franklin a pass on this one since they didn’t exist at the time.
Buffett’s prediction will be recalled and celebrated 100 years from now. Buffett and Franklin will both be remembered as eternal optimists. In Buffett’s words,’“That is not a ridiculous forecast at all, if you do the math on it, it’s an amazing country we live in.” I share Buffett’s sentiment and it is great working with so many clients that are doing their best to earn compound interest and not paying it.
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