Warren Buffett is one of the greatest investors of all time. But he’s also one of the humblest: “My wealth has come from a combination of living in America, some lucky genes, and compound interest”.
I don’t live in America and I’ll never be as wealthy as the Oracle of Omaha. But I can still benefit from what Albert Einstein supposedly called “the eighth wonder of the world“.
That is, the power of compound interest.
Here’s how.
Getting started
I find it amazing that anyone can start investing quite modest sums every month and work their way to a million pounds in around three decades.
This would entail investing £125 a week (or £6,504 a year) and securing an annualised 8.5% return.
| Year | Amount invested | Compound interest | Total |
| 1 | £6,504 | £260 | £6,764 |
| 5 | £6,504 | £7,827 | £40,347 |
| 10 | £6,504 | £36,931 | £101,971 |
| 15 | £6,504 | £98,528 | £196,088 |
| 25 | £6,504 | £396,775 | £559,375 |
| 32 | £6,504 | £865,832 | £1,073,960 |
We can see how the large the compound returns start to become over time. Indeed, this £1m would double in around another seven years, if allowed to continue compounding without interruption.
This is the real power of compound interest, and it explains why Warren Buffett has generated over 90% of his wealth since he turned 65.
Unpredictable
Now, there are a couple of assumptions and caveats here. The first concerns the 8.5% return. I’ve used that because it’s the long-term average return of the FTSE 100 (7%) and S&P 500 (around 10%) combined together.
I believe investing in both indexes would give me better diversification. But there’s no guarantee that they’ll produce such an average return over the next 30 years. It could well be less (or more).
Second, both of these figures are total returns, with dividends reinvested. The easiest way to emulate this is through a low-cost index tracker that reinvests dividends back into the fund (known as accumulating) rather than paying them out (known as distributing).
Finally, the annual returns from the stock market are highly unpredictable and non-linear. For example, the FTSE 100 went up 12% in 2019, before declining 14% the next year. Then it rose 14% in 2021. Last year, it basically ended flat.
Beating the average?
As well as index funds, many investors (myself included) buy shares of individual companies. While this has the potential to turbocharge my long-term returns, it is also more risky. After all, I’m picking a small selection of companies from literally thousands of potentially better options.
So I’m running the risk here that these picks could underperform the average, thereby harming my long-term returns.
It is also much more time-consuming keeping track of my own investments and doing research. That’s why it’s usually simpler for new investors to stick with index tracker funds or take advantage of the expertise of stock-picking services.
Warren Buffett’s holding company Berkshire Hathaway achieved a 19.8% compounded annual gain from 1965 to 2022, compared to 9.9% for the S&P 500. That is an incredible long-term performance and would be almost impossible for me to replicate.
That’s why I combine index investing with stocks I think can beat the average. I reckon this will give me the best chance of generating long-term wealth through compound interest.
