The Power of Compound Interest and Why Warren Buffett Isn’t as Impressive as you Think

https://www.isharad.com/buffett/

You’ve probably come across at least one quote illustrating the power of compounding. There are a million of them out there. Have you heard the Einstein one? “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” or have you heard the one about the Mona Lisa?

“Francis I of France paid 4,000 écus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the écu 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%.” — Warren Buffett, January 1964

Now ponder this fact: 98% of Warren Buffett’s wealth came after the age of 50. To understand how he has accumulated over $85 billion in wealth let’s look at his qualities as an investor.

4 impressive things about Warren Buffett:

1. The fact that he started young and that he has the longevity to keep investing all his life: most of the gains from compounding come in the later years. Buffett has been investing since he was 10 years old and now has an investing career spanning more than eight decades.
2. As a value-investor he understands the importance of patience and time in the market: while other investors may panic during recessions/crashes; Buffett remains calm. Pulling money in and out of investments reduces the time under compounding and starts you back at year zero in terms of the compounding formula.
3. His average return on investment: Buffett’s Berkshire Hathaway has outperformed the market with an average ROI ≈10% higher than that of the market.
4. His frugal lifestyle: even small amounts compounded for many decades grow significantly. For example, Just $1 saved at age 10 would give Warren over 13 million dollars at age 90.

As you can see, all of these impressive qualities of Buffett only help feed and nurture compounding. These qualities maximise every variable of the compounding formula.

1. directly & 2. indirectly increase t, 3 increases r, and 4. increases P

These qualities in themselves are extremely impressive which only a few could replicate, but from a purely mathematical perspective, the power of the exponential is doing most of the heavy lifting.

Warren Buffet vs. an “Average Investor”

Let’s compare the differences in return between Warren Buffett and an “average investor”. For the sake of simplicity let’s assume they both start with $1000. On the one hand, Warren invests for 80 years at a rate of return of 20.5% (this is the commonly reported average yearly ROI of Berkshire Hathaway since its inception). On the other hand, the average investor starts investing in their mid-twenties, say 25, and invests until their retirement, say 65, so for 40 years, and earns the average market rate of 10.5%.

After 40 years of continuously compounding the average investor would have an impressive $ 66,686.33 . This amount is nothing to scoff at but pales in comparison to Warren’s $ 13,256,519,140.46 . If you’re having trouble reading that figure let me just tell you that’s over 13 billion dollars (almost 200 000 times bigger than our average investor).

By no means, is this meant to be a hit-piece on Warren Buffett. I personally find Warren to be one of the most (if not the most) impressive and successful investors out there. It’s merely to show how he has used compounding as a tool to leverage his investments and how his investing qualities are conducive to exploiting its power.