The Magic of Compounding
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The New Slant
Really understanding compounding will make all the difference in investing. I believe that Warren Buffet, the world's greatest investor, is hardwired to think geometrically. He is rich beyond belief because he totally gets the magic of compounding and he executes on the concept. I am going to get these numbers wrong because I'm doing them from memory but it doesn't matter, you'll get the concept. Buffett started a partnership way back when. He had a number of limited partners invest with him and he took a percentage of the gains. In the late 1960s he terminated the partnership with his famous letter, "When you no longer understand the way the game is played, it's time to leave the game." I'm paraphrasing, even though it's in quotes.
Buffett took about $100 million out of that first partnership for himself, so he was working with $100 million, keep that in mind. In 1974 when the bear market bottomed, it might have been early 1975, he started another rise...he took over Berkshire Hathaway. Buffet, since the 1970's, has been getting a compounded (remember that means exponential) growth rate of about 22 to 24%.
This is where I introduce you to The Magic of Compounding's cousin, The Rule of 72. With the Rule of 72 you can calculate how long it will take you to double your money at any given rate of return. OK? So for example, if you're earning 12% on your money and you want to know how long it will take to double it (we're compounding, remember?) divide 72 by 12 and your answer is 6, it will take 6 years to double your money. Do another one. If you're getting 6% on your money, divide 72 by 6 and you'll see that it will take 12 years to double. If you're getting 9%, it's 72 divided by 9, or 8 years to double up.
So for Warren B., he's getting 22% on his money. That means he divides 72 by 22 and sees that, gee, in only 3.27 years, or every 3 years and 4 months, he doubles his money. Since he's been at it about 25 years with that $100 million he had to play with, he's doubled his original $100 million about seven times (25 years dividend by a double every 3 years and 4 months equals 7.69, or let's go with seven even doubles). Remember now, he's not making 7 times his money with the $100 million, that would be an arithmetic progression that would give him $700 million. He's making seven doubles, a geometric or compounded progression.
Warren Buffet's Geometric Progression
Starting Dollar Amount: $100 million Time Periods Involved: Seven 3 year and 4 month periods
|Period||Time Taken||Compounded Gain|
|1||3 years 4 months later||$200,000,000|
|2||6 years 8 months later||$400,000,000|
|3||10 years later||$800,000,000|
|4||13 years 4 months later||$1,600,000,000|
|5||16 years 8 months later||$3,200,000,000|
|6||20 years later||$6,400,000,000|
|7||23 years 4 months later||$12,800,000,000|
I believe Buffett is worth about $15 billion, it could be $20 billion at this point. It doesn't matter, he is somewhere in his eighth double. This is the magic of compounding! Also, he never sells. That means his money is doubling every three years and four months with no tax consequences. He gets taxed only when he sells. The money compounds until he dies, then it's taxed at a capital gains rate in the far distant future. Buffett could not sell if he wanted to because emotionally he can't bring himself to stop the compounding effect.
Teach your children to live a balanced life, and also help them master this concept and you will have very happy and very rich children. In stocks I show you how to make money at the bottom by buying depressed securities that are going to come right back, making you a fortune as they rocket off the bottom. In the future I will also show you how to make money with the Warren Buffett concept, or classical Graham and Dodd analysis. In the mean time, good luck with understanding the magic of compounding and good luck with valuestockplayers.com.
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