The Gist Of Compounding
Most of my listeners know of my love for the power of compounding—it’s a terrific way to grow wealth over time. Compounding works on the principle of investing a set amount of money into stocks or bonds and re-investing your gains back into the pot. Repeat this year after year, be patient, give it 20, 30, 40 years, and you’ll have wealth like you’d never imagined.
If you want to do even better, regularly invest money into that pot every month or every quarter, never withdraw anything, and diligently reinvest your gains. Then sit back, relax, and watch your wealth really, really snowball.
The formula is pretty simple, which is another reason why I love it! I love anything that’s a simple and stable way of passively increasing wealth.
Snowball Your Fortune The Ben Franklin Way
Speaking of snowballing wealth, I just read an article on Seeking Alpha, titled “How To ‘Snowball’ Your Fortune With Benjamin Franklin”, (I’ll put up a link to the article on my website, stevepomeranz.com so you can read it too.)
The article was written by John Thomas, a 50-year veteran of the financial markets, who calls himself The Mad Hedge Fund Trader because he does crazy stuff like climbing Mount Everest, flying 90,000 feet in the cockpit of a Russian jet, and diving to the depths of a sunken Japanese fleet.
In the article, John talks of the investing genius of Benjamin Franklin, one of our founding fathers who was a member of the Committee of Five that drafted the Declaration of Independence and is the face on our hundred-dollar bill (which is why they’re also called Benjamins).
While Ben was an extraordinary scientist, publisher, politician, educator, and man of many more talents, he also understood the basic math behind modern investment theory, more than a century before it was conceived.
There was another thing that Ben knew well ahead of everyone else—that betting against the U.S. was a fool’s errand even though we were the newest nation on earth back in the late 1700s.
Ben’s belief in America went against the widespread sentiment in Europe that our experimental democracy would soon fail. Europe, as you’ll remember, was entirely ruled by kings back in the late 1700s, so the idea that a democracy would survive was met with much scorn.
Betting On America’s Success As A Nation
So deep was Europe’s conviction that America would fail as a nation state that in 1789, a French mathematician, Charles-Joseph Mathon de la Cour, dared anyone to take him on, on a multi-century bet, against the U.S.’s survival as a nation-state.
When Ben learned of this bet, he jumped right in, betting against de la Cour and landing on the side that the U.S. would indeed survive a hundred years and more.
So strong was Ben’s belief in our founding principles that he endowed not one, but two trusts, one in his native Boston and the other in his adopted Philadelphia, with a thousand pounds each, which was about 5,000 dollars back then, and about $100,000 in today’s money—not an insignificant amount.
Ben instructed the trusts to make loans at a 5% rate of interest to young men under the age of 25 to finance their apprenticeships in the trades.
As a side note, I am amazed at Ben’s wisdom and his choice to invest that bet money on apprenticeship programs that trained America’s younger generations to make our nation strong. Wow! He was all in!
Ben specified that half the money be distributed after 100 years, and the balance after 200 years.
The Investment Outcome Of Ben’s Bet
So how did Ben do?
After the first 100 years, his five-thousand-dollar Boston fund had grown to $391,000, for a 4.5% compounded annual return. As Ben had instructed, half of this money was distributed and used to establish the Benjamin Franklin Institute of Technology, which still exists today. The other half stayed invested and grew to $5 million by 1989, 200 years after Ben’s 1789 bet was made.
While the Boston trust did well, the Philadelphia trust did not perform as well, primarily because corrupt politicians raided its coffers early on and diverted funds for pet projects. Even so, by 1989, the Philly fund had grown to about $2 million and was used to offer scholarships to Philadelphia high school graduates.
Sadly, Ben’s trusts did not grow to their full potential of hundreds of millions of dollars because a number of early borrowers defaulted on loans and because funds were grossly mismanaged and misappropriated.
But the lesson still stays. Despite abusive practices, the funds grew nicely in value, even after adjusting for inflation, and Ben’s original mandate clearly shows his understanding of the power of compounding.
The Chess Fable On Compounding
In his Seeking Alpha article, John Thomas illustrates the power of compounding through a famous legend about the origin of chess that goes like this:
When the inventor of the game showed it to the emperor of India, the emperor was so impressed by the new game that he said to the man, “Name your reward!”
The man responded, “Oh, Emperor, my wishes are simple. I only wish for this. Give me one grain of rice for the first square of the chessboard, two grains for the next square, four for the next, eight for the next, and so on for all 64 squares, with each square having double the number of grains as the square before.”
The emperor agreed, amused that the man had asked for such small a reward—or so he thought—until after a week, the emperor’s treasurer informed him that the reward would add up to an astronomical sum, far greater than all the rice that could conceivably be produced in many, many centuries.
That’s the power of compounding!
Now I don’t know how the fable ended, but I am certain the emperor did not fully pay out because that was physically impossible. I just hope he realized the wisdom of the inventor and made him part of his inner circle of advisors. But you never know, back then, beheadings were pretty common if the emperor had a thin skin or a poor sense of humor.
Caveats To Compounding Are Mostly You And Your Emotions
Here’s something I’d like to add. The key to this snowballing of your initial investment is that you avoid being overly active in managing your investments.
Here’s how I’d like you to do it: Pick a few solid companies with stable finances and good long-term prospects, ideally with decent dividends too, then add to this portfolio every month, every quarter or every year, the best that you can.
Don’t trade in and out and waste your money on fees and commissions, don’t try to time the market, don’t dump when the market crashes, don’t speculate on hot stocks, don’t let your emotions get the better of you…and you’ll be fine. As simple as this sounds, there is a hard part, and that is keeping your desire for action and your emotions out of the equation.
If you get overly active or try and second-guess the market, your results won’t be all that impressive. In fact, I wouldn’t be surprised if you end up losing money by being overly active in managing it. So, if you want your wealth to grow, invest it in a few good stocks or index funds, reinvest your dividends back into those them, and forget about it for 20 or 30 years.
If you really want to see some magic, add to your portfolio every month or quarter and watch your wealth snowball.
Okay, wrapping up, let me just add this. With respect to the just finished Berkshire Hathaway’s annual shareholders meeting, I am also reminded of Warren Buffett and the two things he shares in common with Benjamin Franklin: his belief in the power of compounding to snowball your wealth, and his other belief that it’s always a terrible idea to bet against America.
So, my friends, may the force of compounding be with each and every one of you, and I sincerely hope you use it well to grow your wealth.
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Sources:How To ‘Snowball’ Your Fortune With Benjamin Franklin