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IF I MADE A LIST of all the dumb things investors do, I likely committed them all. I chased performance, sold stocks in a bear market, invested in things I didn’t understand—you get the picture.
Yet, despite the numerous setbacks I suffered before I matured as an investor, I was able to retire comfortably. How was that possible? My conclusion: compound growth. Indeed, I believe compounding is a surer way to wealth than picking market-beating investments. That belief originated with, and was reinforced by, Warren Buffett.
The book Warren Buffett’s Ground Rules, written by Jeremy Miller, details lessons to be learned from Buffett’s annual letters to Berkshire Hathaway’s shareholders. The book’s second chapter is devoted to compounding. Here are three highlights from that chapter:
1. “The power of compounded interest is unmatched by any other factor in the production of wealth through investment,” says Buffett. “Compounding over a life-long investment program is your best strategy, bar none.”
The words “bar none” jumped out at me. Here is one of the world’s most astute investors saying that compounding trumps stock picking when it comes to building wealth over the long-term. That was an eye opener.
One of Warren Buffett’s favorite long-term holdings is Coca-Cola. He started purchasing shares in 1988. Today, it’s the fourth largest holding in Berkshire Hathaway’s portfolio. According to Buffett, “The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks.”
I’ve owned Vanguard Total Stock Market Index Fund (symbol: VTSAX) in my taxable account since 1998, and have reinvested distributions and purchased additional shares over the years. In 2022, this one investment yielded more than $13,000 in dividends. In the future, if I request that Vanguard direct those distributions to my money market fund, I’ll enjoy a nice boost to my retirement income courtesy of the U.S. stock market—and at the lower tax rate for qualified dividends.
When I think about my history with this fund, I realize that what was most important was the steady accumulation of dividend-paying shares, not a rising share price. Long-term investors might consider tracking the number of shares they own rather than the dollar value of their investment. An exponentially growing number of dividend-paying shares is what compounding looks like.
2. “Compounding derives its power from its parabolic nature; the longer it goes, the more impactful it becomes,” Buffett has written. “However, it does take significant amounts of time to build sufficient scale.”
We’ve all seen those graphs, with their upwardly sloping curves, that are used to illustrate compound growth. These graphs have three noteworthy characteristics. First, early returns have a modest impact and the power of compounding isn’t readily apparent. I often wonder if some people look at these early returns, conclude that compounding doesn’t work and then turn their attention to other investment strategies.
Second, the timeline in many of the graphs extends to 30 years or more. Patience is a virtue. Due to increased longevity, many recent retirees likely have two or three decades ahead of them. When trying to overcome the effects of inflation, compound growth can be as important to retirees as it is to younger investors.
Third, compound growth from reinvested dividends happens automatically and doesn’t require you to do anything. Compare this to the effort needed to choose individual stocks or do your own taxes.
3. “Small fractional changes in the compound rate produces hugely different outcomes over long periods,” notes Buffett. “Fees, taxes, and other forms of slippage can add up to have an enormous cumulative impact. While 1-2% a year in such costs seems minor when isolated to a given year, the power of compounding turns something that looks minor into something colossal.”
Consider an investor over a 30-year period earning a 5% average annual return after expenses, versus a pre-cost 7%. Missing out on those two percentage points yields a final result that’s half what it could have been.
Buffett states that, “Fees and taxes… have been crushing the long-term investment performance of most Americans.” He advises us to, “Avoid fees and taxes to the fullest extent practical.”
That’s why investing in low-cost, broad-based index funds is so appealing. But such investments must be bought and held. The more you trade, the more likely you’ll disrupt compounding and need to start over again, losing precious time.
Shlomo Benartzi, a professor at the University of California, Los Angeles, coined the term “exponential-growth bias” to describe people who are unaware of the effects of compound interest. He hypothesizes that such people think their savings grow linearly, not exponentially, and thus underestimate the benefits of long-term investing. Those with a linear mindset may conclude that it’s relatively easy to make up for lost time, and decide to postpone saving in favor of other, more immediate needs. But ask those trying to make up for lost time, and they’ll tell you that it’s far from easy.
Keep in mind that compound growth has a dark side. Inflation, the enemy of all investors, also increases exponentially. Each year’s inflation rate builds on last year’s rate. Aside from excessive debt, inflation is probably the biggest obstacle to wealth creation that investors face. We can use all the help we can get to earn positive real returns.
When trying to build wealth, compound growth is one of the few winds at our back. I’d like to see it emphasized far more frequently than it is currently. Too often, investment discussions seem skewed toward beating the market—and that’s a shame.
Philip Stein, currently retired, was a public health microbiologist and later a computer programmer in the aerospace industry. He maintains that he’s worked with bugs, in one form or another, his entire career. Phil and his wife Jeanne live in Las Vegas.
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Excellent article that gets to the core of investing, Philip. My wife left a job in 1990 and rolled her tiny, $3,000 401k balance into Vanguard Wellington. Not one change has been made to that investment in 33 years, and the current reward is a 1,720% cumulative return, to $54,600 (and the return was higher before the 2022 bear market). Further proof of your (and Warren Buffett’s) point about compounding — even a balanced fund (and a managed one at that) can produce noticeable returns over time with, literally, zero effort.
I started investing in stocks at age 22 by maxing out my Roth IRA, adding to my 401K to get the full match, and to a brokerage account when I had the extra cash. We hit the million mark at age 43 because of the power of compounding. It’s truly amazing to see the dividends and capital gains reinvested now. This is a great article that everyone should read.
Great article, Philip. Particularly relevant for the younger crowd. I tell my younger clients that, while returns matter, starting early and saving as much as you can has way more impact on future wealth. The investment piece is comparatively easy: set it and forget it with a good low-cost target retirement fund or simple indexed portfolio. Forget trying to find the “next big thing” in investing and focus on how to save more!
As other commenters have mentioned, compounding isn’t limited to dividend-generating stocks. On a broader level, it’s really using the value of time to build upon a sensible foundation, which in turn is probably helped by some sort of diversification, as putting all one’s eggs in a single basket where they either don’t hatch or don’t grow negates any compounding effect.
Vanguard Total Stock Market Index Fund appears to have been a good long term decision for decades for a US diversified portfolio. Most of my equity investments have been in my former employer’s traditional 401(k) plan and the nearest plan option in diversification and cost was the Vanguard S&P 500 VFAIX which was adequate for me while I was an active plan participant.
I have currently begun taking just the RMD from my 401(k) account as I wait for a period of less market volatility to move the bulk of my 401(k) to my traditional IRA. Regrettably, my 401(k) plan does not allow for an in-kind transfer of investments and with the exception of RMDs has to be distributed or rolled over as a lump sum.
My home country bias makes me uncomfortable going all in on a total world equity index but I expect I will likely choose an allocation of 50% to VTWAX (Total World Equity Index) of the equity portion of my assets with the remainder in a US S&P 500. I think about a world equity index fund as a better hedge against future changes than a US only total index fund.
I plan for my IRA assets to be converted over multiple years from my traditional IRA to my Roth IRA in a manner so that I can control the tax cost of conversions.
Absent of a major unanticipated financial event for my wife or me I expect the VTWAX investment in the Roth will go to our kids decades from now and our holding period will be the joint life of my wife and me.
William, I mentioned Vanguard’s Total Stock Market fund because I’ve personally owned it. But funds like Vanguard’s S&P 500 and Total World Equity fund (along with many others) are perfectly fine alternatives.
My point is to hold for the long-term and reinvest your distributions. Do that and you should achieve similar results.
I’m confident your children will someday be very grateful to you for using that approach.
I wish I had lunch with you 50 years ago. Over that time I invested about the same amount of money in stock funds and real estate. I loved the market and quite literally played the game, lunging for diving catches. I kept the small unimposing properties mostly for diversification.
By chance, I live in a sleepy government town where people make decent and predictable salaries and enjoy ample pensions. Disinterested in the real estate, I rarely visited the houses and duplexes, which my wife would refer to as blind neglect. But I had a frugal and diligent property manager who followed my MO of keeping good renters by barely raising rents but keeping expenses under tight control. I never sold any of the properties.
Life can be so ironic. I am now financially comfortable, almost exclusively because of the compounding real estate. I guess I was a kind of real estate index fund with a modest portfolio of small income properties strewn across unimposing houses and duplexes in middle-class neighborhoods in Sacramento.
Thank you so much for the article. I am sending it to my son, who will someday have the properties and still has those 50 years.
Steve, thank you for pointing out that compounding works with many different types of investments, not just total market index funds.
In assume that the source of compound growth in your case were periodic purchases of additional properties over the years.
,
Yes, Phil, you got that right, too, but actually almost all in the early 1980’s, 40 years ago.
Every investor is different. Every investment story is different. I’ve been in the stock market for 40 years, but my retirement nest egg came from compounding… homes. I bought a home, lived in it, sold it for a profit, reinvested the profit into a more expensive home, lived in it, sold it for a profit, rinse and repeat twice more. If that isn’t compounding, I don’t know what is.
However, the initial down payment for my most profitable home came from a growth stock, CSCO, that had gone up 16X. I was forced to sell it to buy the house for a wife who didn’t stick around. By sheer luck, I sold at the absolute peak, a price CSCO has never again approached in the subsequent 23 years. If not for that, I likely would never have been able to initiate that real estate cycle.
So luck matters too. A lot. With investments, and with second wives.
Mike, like Steve Abramowitz, you are correct in pointing out that compounding works with many types of investments, not just stocks.
Luck certainly smiled on you when you sold CSCO at its peak price. But I don’t see luck playing much of a role in compound growth. Luck appears to play more of a role when buying or selling investments.
I agree with the main points but a rising share price can be just as (or more) important to compound growth as reinvested dividends. This is true not just for stocks which don’t pay a dividend, but also for total market funds like VTSAX.
Go back to 1998 and invest $10,000 in the total US stock market (use VTSMX since the Admiral shares weren’t around yet).
With no additional contributions but with dividends reinvested, today you’d have $67,666.
With no additional contributions and without dividends reinvested, today you’d have $43,883.
For the most part I think this is a great article and reminder of the magic of compounding, but I disagree with statements like, “I realize that what was most important was the steady accumulation of dividend-paying shares, not a rising share price.” In the end, total return is all that matters, whether that’s achieved by dividends, share price appreciation, or a combination of both.
Brent, you are correct when you state that total return is important, not just dividends. Raising cash by selling appreciated shares is no different than spending a dividend.
What I meant to imply by the statement you cite is that I believe investors do themselves a disservice by focusing solely on share price. That can lead to emotional decisions that may be harmful to one’s financial future.
If you instead focus on accumulation of shares, you may be less prone to panic in a bear market when selling could be most destructive.
Much truth in what you wrote. Excellent stuff.
I have bought dividend-paying stocks all my life, and held on to them. Thirty years ago, of course, you paid a commission, but nowadays there is no-commission trading, so your expense ratio is 0%. This method does work, and you will make money.
Of course, investing over not investing is always better. However, given a longer timeframe (30+ years certainly qualifies), an investor would likely be better off in growth vs. dividend (link) in most instances.
Economic theory says that all classes of assets should provide the same overall return for the same level of risk. However, over the long term, value investing seems to out-perform growth investing.
I believe that this is because all growth stocks are priced as if their growth was a certainty. Sure, some of them grow more than expected, but many prove disappointing. Right now, for example, Amazon is priced at 50 times trailing earnings. If you use a seat-of the pants valuation formula like:
Fair value = EPS x (7 + Growth rate) x 5 / AA Corporate bond rate
What sort of growth rate does that imply? Where will all this value come from?
Also true and value doesn’t necessarily equal dividend.
I’d like to point out that Vanguard’s Total Stock Market fund is not a dividend-focused fund. It is a broad market index fund that distributes dividends.
Also, a broad market index fund will contain both growth and value stocks, so an investor can get growth exposure as well. It could be reasonable for younger investors to further tilt their portfolios to growth if they can stand the increased volatility and hold for the long-term.
Correct, and I always use total market. It is likely most here do. I always just try to argue with the dividend folks to cause trouble. 🤣
Time and Compounding=Weath. Great article that any novice investor should digest. The Rule of 72 works wonders