The Magic of Compounding

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The Magic of Compounding

During the frequent conversation between a space shuttle crew and mission control in a space shuttle launch sequence, you would typically hear a command from the flight control center of “Houston. Go at throttle up.” This happens about one minute after the shuttle leaves the launch pad. Sadly, although the acceleration was unrelated to the subsequent explosion, this command was the last verbal communication between mission control and the crew of the Space Shuttle Challenger before it exploded in a ball of fire in January of 1986. The vessel was at about 48,000 feet of altitude when that command came.

It would seem as if the rocket would be traveling at top speed already as it streaks away from Earth and would not need an additional boost of power. However, while the rocket is gaining altitude at a tremendous velocity, aerodynamic forces keep it from travelling at full speed until the rocket rises to an altitude with much thinner air. Gaining altitude at full speed in the thick air near sea level would put too much pressure and aerodynamic drag on the rocket and would tear it apart. It would be like slamming into a brick wall. Hence the call for “go at throttle up” when the ship arrives at a safe altitude with thinner air.

The ship would then accelerate to its maximum velocity to slip the surly bonds of gravity and continue on its journey to space. In the language of astrophysics, a Max-Q point is the altitude level where the increasing speed of the rocket is outweighed by the decreasing density of the atmosphere as the rocket climbs higher, and the air pressure and aerodynamic danger decreases from that point on. It is then safe and easy to shoot higher on its mission to space.

The investment equivalent to throttle up is the power of compounding and the benefits of compound interest. In simple terms, compound interest means that an investor begins to earn interest income on his interest income, resulting in his money growing at an ever-accelerating rate. Like a rocket after launch, in the initial years of an investment, the account balance struggles to gain much traction, but later on these small gains become large gains.

For instance, if you invested $1,000 and earn a 10 percent interest rate, then at the end of year-one you have $1,100. If you then earn 10 percent of interest on that new higher total, then you end up with $1,210 at the end of the second year. Not only does your initial investment earn interest, but the interest that you have earned and left in the account also then earns interest. At the end of the fifth year, you will have $1,611. At the end of the tenth year, you will have $2,594, and at the end of the twentieth the amount will have grown to $6,757.

The longer the time frame that you can compound a sum, the greater the effects of compounding. A rocket ship finds it easier to gain altitude the higher the ship goes. That’s because the air is thinner and there is less resistance. Similarly, the power of compounding makes it far easier to earn an additional dollar the larger the account balance and the longer the time frame for compounding.

Starting the compounding journey while young is especially powerful. For example, let’s look at three investors. Troy saved $1,000 per month from the time he turned twenty-five until he turned thirty-five. At that point, he stopped saving but left his money in his investment account where it continued to grow at a seven percent rate until he retired at sixty-five.

Carla went to medical school and didn’t start saving until age thirty-five. She put away $1,000 per month from her thirty-fifth birthday until she turned forty-five. She also then stopped saving but left the balance in her investment account where it continued to compound at a rate of seven percent until she was sixty-five.

Harry did not know about the power of compounding and didn’t get around to investing until age forty-five. Still, he invested $1,000 per month for ten years, and stopped saving at age fifty-five. He also left his money to accrue at a seven percent rate until his sixty-fifth birthday. Troy, Carla and Harry each saved the same amount, $120,000, over a ten-year period. But due to the power of compounding, their ending balances were dramatically different.

Account balance at age 65:

Troy:  $1,125,365

Carla:  $572,079

Harry: $290,816

There is no brilliance in harnessing the power of compound interest to grow wealth over time. An investor simply needs patience and a long-time frame, and the power will work by itself. Start early. Invest often. Don’t touch the balance. And magic will happen to your small investment over time.