In our post on Diversification and our recent 60/40 vs S&P 500 analysis, we explored how different types of portfolios behave and why a smoother, diversified strategy can help real investors stay invested.
But that still leaves one critical question: Why invest in the first place?
The answer is something Albert Einstein reportedly called the “eighth wonder of the world.” He said, “He who understands it, earns it; he who doesn’t, pays it.”
He was talking about the power of Compounding.
The Snowball Effect
Think of the power of compounding like rolling a snowball down a hill. At the top, it is small. As it rolls, it collects more snow. But as the snowball gets bigger, its surface area expands, and it collects snow faster. In finance, this is “interest on interest.”
Here is the difference:
- Simple Interest: 10,000 dollars at 10 percent earns 1,000 dollars a year. After 20 years: 30,000 dollars.
- Compound Interest: 10,000 dollars at 10 percent earns interest on both your money and past interest. After 20 years: 67,275 dollars.
(Source: Compound Interest definition Investor.gov)
For the “Nerds”
If you want to understand the math behind the power of compounding, here is the formula:
Future Value = P × (1 + r)n
- P = your starting amount (principal)
- r = annual rate of return
- n = number of years invested
Example: 10,000 dollars invested at 8 percent for 30 years becomes:
10,000 × (1.08)30 = 100,626 dollars
If you want to understand why your snowball bends upward over time, here is the intuition.
- Exponential Growth: Each period builds on a larger base than the last. Your portfolio grows slowly at first, then faster, then explosively as the slope steepens.
- Doubling Time: Each doubling adds more dollars than the last. Going from 10,000 to 20,000 feels small. Going from 250,000 to 500,000 feels massive, but mathematically it is the same jump.
- Contribution vs Growth: In the early years, your contributions matter more. In the later years, compounding overwhelms contributions. This is why Ellie beats Larry even though she invested far less.
- Most of Your Wealth Comes at the End: In a typical 30 to 40 year horizon, more than half of your total ending value is generated in the final decade.
Compounding is not linear. It is not intuitive. But once you see how the curve behaves, you understand why every investing professional stresses time in the market over everything else.
The Two Levers: Rate and Time
There are only two things you can control in compounding: Your Rate of Return and Your Time Horizon.
1. The Rate (Why Investors Buy Stocks)
The difference between earning 2 percent in cash and 8 to 10 percent in equities becomes enormous over decades:
- 10,000 dollars at 2 percent for 30 years → 18,113 dollars
- 10,000 dollars at 10 percent for 30 years → 174,494 dollars
That extra volatility investors face is the price of admission for much higher long-term rewards.
2. Time (The Cost of Waiting)
You can always invest more money later, but you can never buy back lost time.
Consider two investors earning 8 percent annually:
- Early Ellie: Invests 5,000 a year from age 25 to 35 (10 years), then stops. Total invested: 50,000.
- Late Larry: Invests 5,000 a year from age 35 to 65 (30 years). Total invested: 150,000.
At age 65:
- Late Larry: ~566,000 dollars
- Early Ellie: ~728,000 dollars
(Source: Power of starting early Fidelity)
The Rule of 72
The Rule of 72 is a quick mental trick to estimate how long it takes your money to double.
- 2 percent return: 72 ÷ 2 = 36 years to double
- 10 percent return: 72 ÷ 10 = 7.2 years to double
(Source: Rule of 72 Investopedia)
See It in the Analyzer
You can visualize this effect using the Zorroh Portfolio Analyzer:
- Go to analyzer.zorroh.com
- Select the S&P 500 (SPY) and allocate it a 100 percent weight
- View the Cumulative Performance chart
Notice how the curve steepens over time. That upward bend is the snowball getting larger and working harder on your behalf.
Conclusion
Time is the most powerful asset in your portfolio, more powerful than picking the perfect stock or guessing the right moment to enter the market. The best time to start was 20 years ago. The second best time is today.
Now that you understand why we invest (power of compounding) and what to invest in (a diversified, disciplined portfolio), our next post will cover how to enter the market confidently.
Stay tuned for our next article on Dollar-Cost Averaging (DCA), the strategy that turns volatility into an ally.
Disclaimer:
The content on this blog (“Zorroh”) is provided for general informational and educational purposes only. It is not intended as investment, financial, tax, legal, or other professional advice. Past performance is not indicative of future results. Investing involves risk, including possible loss of principal. Always conduct your own research or consult a qualified professional before making investment decisions.