Even as a youngster, Warren Buffett was already thinking about compound interest, an important way to generate wealth. He understood that once you make an investment, it can earn interest. And then he could start earning interest on that interest (plus his original investment.) And if he let that process play out over time–especially long periods of time–the profits could start to snowball, becoming quite large. The concept of compound interest is perhaps better explained visually. So we would encourage you to watch the Investopedia video below, and really let the concepts sink in.
When thinking about compound interest, it’s essential to focus on the importance of time. Charlie Munger, the Vice Chairman of Berkshire Hathaway, once quipped “The first rule of compounding is to never interrupt it unnecessarily.” By this, he meant that significant profits accrue when you let interest compound over long stretches of time, with the greatest gains coming during the later years of the investment. Hence, in Munger’s view, you never want to interrupt compound interest by prematurely selling or diminishing your investment. Benefiting from compound interest requires patience and sometimes fortitude.
To help further illustrate the importance of time, Morgan Housel made this observation in The Psychology of Money (2020):
As I write this Warren Buffett’s net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s. Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three quarters of a century…. Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. His skill is investing, but his secret is time. That’s how compounding works.
For Buffett and Munger alike, successful investing comes down to picking strong assets that will appreciate over time. That’s a given. But, almost as importantly, investors need to hold those strong assets for a good duration, allowing compound interest to work its magic.
As a final note, we should underscore that compound interest can help investors, but it can also hurt those carrying debt, particularly credit card debt. Famously but probably apocryphally, Albert Einstein once called compound interest the “eighth wonder of the world,” adding: “He who understands it, earns it. He who doesn’t, pays it.” In other words, he meant that investors who understand compound interest can generate significant wealth. And those who don’t understand compound interest can lose significant sums when the interest on their debt compounds and spirals out of control. The CNBC video below covers both the upside and downside of compound interest. It’s worth a watch.
