The Markets Up Chuck

There is an undetermined Urban Legend that Albert Einstein once said compounding interest is the most powerful force in the universe. Whether Einstein actually said that or not, the power of compounding cannot be denied. There is a handy rule of thumb known as the Rule of 72 that illustrates its power. Take any rate of return and divide it into the number 72 to determine how many years it takes to double. At 10%, divided into 72 it takes 7.2 years to double. At 20%, divided into 72 it takes 3.6 years, or precisely half the time. Pardon the mathematics; however, understanding the relevance of this principle is enlightening regarding investing.

For illustration purposes, I am going to choose numbers that divide out evenly. Let’s examine what would happen in 36 years, we will call this a lifetime of work, comparing getting a 10% return versus a 20% return. Since it takes 7.2 years to double at 10%, if we divide 7.2 years into 36 years we get 5 doubles (5 x 7.2 = 36). Therefore, over 36 years a dollar invested would double 5 times as follows: $2, $4, $8, $16, $32. Therefore, a 10% average return would turn a dollar invested into $32. However, if we double the return to 20% growth we cut in half the time to double to 3.6 years and therefore double the doubles (3.6 divided into 36 years = 10 doubles). Therefore, if we double that same dollar 5 more times as follows we get: $64, $128, $256, $512, $1,024. Herein lies the power of compounding, 10% growth turns a dollar into $32, while 20% growth turns it in $1,024. That equates to 32 times more money. Today’s FRAT™ Videx™ looks at two examples of this powerful force at work. Enjoy!

FRAT™ VidEx™ (click to open in full screen)

The author manages portfolios owning SYK.

As I have illustrated in numerous past blog posts using FRAT™ Videx™, there are many high quality companies that have achieved 10 – 20% earnings growth and therefore comparable long-term returns for their shareholders. Don’t you also find it interesting that the companies achieving these results are best of breed industry leaders? In other words, the best investor returns are coming from the best companies. If you choose the best companies, and are careful to only pay sound valuations when buy them, there is no reason to believe that you can’t enjoy the same benefits. Indexing is for the ignorant; be knowledgeable and richer.

Tags: compounding, Rule of 72, Stryker

This entry was posted on Tuesday, April 28th, 2009 at 12:30 pm and is filed under Valuation. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.