How to Build Great Wealth With the Power of Compounding

The time to start using the power of compounding is today. Forget your past performance and work on keeping losses limited as you build your portfolio and produce returns.

Albert Einstein is credited with saying, “Compound interest is the eighth wonder of the world. He who understands it earns it, he who doesn’t pays it.” Benjamin Franklin described compounding as: “Money makes money. And the money that money makes money.”

One of my favorite illustrations of compounding is that if the $24 that was used to buy the island of Manhattan from the Lenape Tribe in 1626 was invested in a bond at 8%, it would be worth about $44 trillion in 2023.

If you would like a rough estimate of how fast compounding will grow your money, then use the Rule of 72. If you divide 72 by the return you hope to earn, that number gives you the approximate number of years it will take for your investment to double. For example, earning a 6% annual return will double your money in about 12 years (72 divided by 6). If you earn a 12% annual return, then you will double your money in just six years.

Compounding profits is what has built most of the great fortunes in history, but it is a misunderstood phenomenon, and many investors fail to use it effectively.

Most investors think that compounding only applies to buying and holding a single stock. Warren Buffet is the best-known illustration of this approach. He bought and held names like Coca-Cola (KO) and Apple (AAPL) and enjoyed huge returns because of compounding.

The Secret to Compounding

Here is the secret to compounding that most people overlook – you can benefit from it even if you aren’t lucky enough to buy a great stock and hold it for many years. Good investment selection helps, but compounding will work for you if you keep your accounts near their highs and consistently can produce good returns. You can do this with a single stock like Buffett, or you can do this with dozens of stocks and very short-term trading.

The primary risk of buy-and-hold investing is that you are in the wrong asset. Compounding works against you if you are holding the wrong asset. The reason that very few people can duplicate what someone like Buffett does is that they do a very poor job of finding stocks that are going to produce exceptional returns for decades. It is one of the hardest things to do in investing, and that is why there are so few people that become very rich doing it.

Rather than trying to find one of the very few stocks that will be great investments for decades, the less risky approach to compounding is to not withdraw capital and to make sure that the assets you are holding stay as close to highs as possible.

With a bank account, the dollars you invest don’t go down in value, but the level of returns will be limited. With stocks, there will always be the risk of volatility and loss. That is what will kill the compounding effect if it lasts too long. However, if you produce strong returns with limited drawdowns for a long period of time, then you will benefit greatly from compounding.

The important issue here is to think of your portfolio of stocks as a single asset. Your portfolio is the equivalent of Buffett’s investment in a single stock. The aggregate of all your stocks and trading activity can be viewed as the equivalent of simply holding one stock, such as Apple (AAPL) . This change in focus requires some hard work. It requires you to manage that asset via active trading and to make sure that drawdowns stay small and your capital produces good returns.

Enhancing Your Returns

Ultimately all that matters is that the portfolio remains near its highs and produces some level of returns over a long period of years. The fact that you may have made thousands of trades in hundreds of stocks doesn’t curtail the power of compounding. It may actually enhance your returns. Even stocks like Apple suffer drawdowns of 50% or more on their upward trek over many years. It is possible to reduce volatility through very active trading if that is a primary focus.

Rather than just try to find a few good stocks to hold, focus on carefully managing the stocks you do hold. Those that don’t help keep your account near highs are eliminated, and those that help it grow faster are added. If you do this effectively, your asset base will grow, and the compounding effect will be even better than that enjoyed by passive holding over the very long term.

Obviously, this approach is more work than finding a single great stock to hold for a very long time, but it also reduces risk. If your account is going the wrong way, you cut your losses, regroup and look to find the stocks that will perform better in the future.

Most people fail at compounding their investment accounts because they withdraw funds or suffer too many big drawdowns and never recover. They suffer a big loss and then must go through the very unproductive task of just returning to the point where they were. Think about your portfolio as if it were a single asset that you are going to grow at a compound rate for many years.

Successful buy-and-hold investing is nothing more than using the power of compounding. Active traders are in a far better position to benefit from compounding than buy-and-hold investors if they do it right.

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