Editor’s note: This article was first published in August 2014; the Business Insider figures on Warren Buffett’s net worth (63 billion dollars), his wealth at 50 and his age are from that time. The estimate of what he would have had by investing in Berkshire Hathaway is unsourced.
There is a story (a myth or a legend) about the man who invented chess.
The inventor went to see the emperor of China and showed him his creation, the game of chess. The emperor was so amazed that he wanted the game for himself, so he told the young inventor that if he let him have it, he would grant him a wish.
And the inventor asked for something very simple: one grain of rice for the first square of the board, 2 grains for the second square, 4 grains for the third, 8 for the fourth, and so on until the last square of the board.
The emperor quickly agreed, because he thought the request was very modest. He even felt he had tricked the young man by getting his invention for a few grains of rice. But when the emperor went to pay, and worked out the grains needed as the squares went on, he discovered that to fill the last 10 squares of the board he would need 35 quintillion grains of rice. There wasn’t enough rice in all of China to pay the inventor. The emperor then felt cheated and ordered the inventor to be killed.
I don’t think the story is true, but we often use it as an example to explain the magic of compound interest, as well as Christopher Columbus’s cent, which 500 years later becomes 95 billion. But there’s a problem with compound interest: its effects aren’t noticeable at the beginning, only at the end.
Warren Buffett is a clear example. 99% of Buffett’s fortune was made after his 50th birthday. That means Buffett’s current net worth of 63 billion dollars is the result of the roughly 600 million he had made by the age of 50. Remember that Buffett will soon turn 84.
Another fact, as curious as it is ironic: if Warren Buffett had invested those 600 million in shares of his own company, Berkshire Hathaway, at the age of 50, today he would have more than 300 billion dollars.
(Read: This is how rich you’d be if you had invested €1,000 with Warren Buffett)
The secret to building wealth with compound interest is reaching the last squares of the board, even though the first squares may be rather boring and not very attractive financially. That’s why veteran investors say that good investing is like watching grass grow; if you want excitement, go to a casino.
It takes a long time to work and a lot of patience to watch it grow. But most people don’t have that patience. And that carries over to share dividends.
Suppose you have 1,000 Apple shares, and the company is going to pay a 5% dividend that you can take in cash or in shares. If we take that money in cash and spend it, it’s money lost that leaves our investments, so it isn’t advisable if you’re putting together a long-term investment plan. The most profitable option is to take the dividend as new shares, which would be about 50 new shares.
Compound interest works with dividends too, because next time we won’t be paid a 5% dividend on 1,000 shares but 5% on 1,050 shares, which would be 52.5 new shares.
The time after that we would receive 5% of 1,102 shares, and so on, until we have built up thousands of new shares that pay us an ever-larger dividend each year. Together with the appreciation of the shares, that is how you build wealth on the stock market and create that precious asset whose dividends, in time, we can start taking in cash.
Of course, we also help our compound interest if, as well as adding the interest generated to the principal, we increase our income and raise the capital we set aside for investing.
For all this and more, the advice is to start saving and investing as young as possible, because if you start too late, compound interest won’t have time to do practically anything.
We’ve already seen the huge difference between starting to save at 25 and at 35, and how ridiculously small the amount is that you need to save each month to retire with 1 million euros, an amount that rises dramatically as the years go by.
Further reading
- 5 steps to building a dividend investing strategy
- The best investment advice an investor can get
- 34 lessons about money: the definitive guide to financial education
Featured image: MartinThoma, CC BY 3.0, via Wikimedia Commons.
