The power of compounding

As a prominent historical figure, there are few who could match the accomplishments of Ben Franklin. Founding Father, Diplomat, Scientist, Inventor, Politician and Publisher exemplified some of the roles he occupied during his remarkable life. Beyond helping to draft the Declaration of Independence and the U.S. Constitution, helping to negotiate the Treaty of Paris, which ended the Revolutionary War, publishing Poor Richard’s Almanack and inventing bifocal glasses, Ben Franklin’s understanding and demonstration of the power of compounding underscored his financial acumen and provides a valuable financial lesson for all.

When he died in 1790, Ben Franklin bequeathed in his will, 1,000 pounds sterling, which was the equivalent of $4,444, to each of the cities of Boston (his native city) and Philadelphia (his adopted city). This act allowed him to sponsor civic virtue and satisfy his fascination with the power of compounding interest. He requested that for the first hundred years, each of the 1,000 pounds sterling would accrue interest and be used to fund loans for young married tradesmen starting out in business. At the end of 100 years, the cities would be allowed to spend 75% of the principal of the money on public works. The remaining 25% was to remain invested until another 100 years had passed, at which time the cities would be allowed to spend that on whatever they wanted. Franklin’s objective was to help people understand the importance of compound interest. As Franklin himself liked to describe the benefits of compounding, “Money makes money. And the money that money makes, makes money.”

The compounding paid off for both cities. By 1990, over $2 million had accumulated in Franklin’s Philadelphia trust. Franklin’s Boston trust fund had grown to $4.5 million, more than twice the amount in the Philadelphia trust fund. Ben Franklin’s financial lesson proved enormously astute.

Granted, nobody has even 100 years to compound investments, let alone 200, but the concept of starting early, investing regularly, staying disciplined and patient, and allowing compounding to do the heavy lifting cannot be understated when it comes to investing. Most investors have a 30-year to 40-year horizon. Saving and investing regularly is imperative to achieving financial goals. Remaining disciplined during times of market stress and not trying to time the markets are critical components of wealth building. Staying disciplined, invested and re-investing can prove hugely beneficial over the long-term due to compound interest and compound returns.

The chart below illustrates and helps to visualize the power of compounding by showing the monthly savings required to reach $1 million at retirement (assumed to be 65 years of age) at various ages. The earlier one starts, the longer the compounding runway, and the smaller the monthly savings required to reach $1 million.

Source: Business Insider

However, it is equally important to note that compounding can also work against you. An example of this would be when high-interest credit card debt builds on itself over time. Here, compounding serves as a powerful inducement to pay off your debts as soon as you can and start saving and investing your money early.

And, if further confirmation of the power of compounding is needed, it is rumored that Albert Einstein described compound interest as the eighth wonder of the world and said that those who understand compound interest, earn it. Those who do not, pay it.

~ James Callahan, CFA