Compound Interest May Not Be Einstein’s Eighth Wonder, But It’s A Powerful Tool For Investors

Albert Einstein is famous for saying, “Compound interest is the eighth wonder of the world. He who understands it, wins it; whoever doesn’t pays for it.The Associated Press

If you invest a sum of money at 10% for five years, you will multiply your wealth by 1.6 times.

If you invest your capital at this rate for 10 times longer (50 years), you multiply your wealth by 16 times.

You will multiply it by more than 117 times.

Does that surprise you? It should be, because exponential growth (also known as compound growth) is hard for the human mind to grasp.

Understanding it, however, is the source of successful investing. Albert Einstein is famous for saying, “Compound interest is the eighth wonder of the world. He who understands it, wins it; whoever does not, pays for it.

Back to basics. Investing is simply putting a sum of money aside for a period of time with a view to receiving a lot more money, in real terms, in the future.

Your success as an investor is a function of two things:

  • your net return on investment over time;
  • how long you stay invested.

What determines your long-term rate of return? Studies have shown that by far the most important factor is the asset class in which you invest. Investing in a portfolio of growing companies, by owning publicly traded or private companies, will produce the highest unleveraged return.

The only return that matters is your long-term return and, for most asset classes, your long-term investment return is reasonably predictable. History tells us that, over 20 years or more, assuming inflation is reasonably moderate, your average annual return from an investment in a portfolio of listed companies (equities) is likely to be between 7% and 10%, before taxes.

Any tax paid on your return on investment will, of course, reduce this amount. This is one of the few certainties in investing. Investors are only taxed on their capital gains when the asset is sold. So there is a huge upside to holding each of your investments for the long term. As Warren Buffett put it, “Investors who pay taxes will make a much, much larger sum from a single internally compounded investment at a given rate than from a succession of internally compounded investments. same rate”.

Almost everyone focuses more on the rate of return than on how long their capital will be invested. However, to benefit from compound growth, it is essential to consider both factors – and your ability to change the investment period is far greater than your ability to change the long-term rate of return. “Buy right and hold tight” is a slogan embraced by some of the world’s most successful investors.

This long-term maintenance approach explains why nearly all of the world’s great family fortunes (think Buffett, Gates, Thomson) were created by holding shares in a growing company for many decades, allowing their value to soar. accumulate over time. on a pre-tax basis.

However, there is a limit to how long individuals can build their wealth tax-free. When you die, you are deemed for tax purposes to have disposed of your investments. Therefore, your estate is taxed on your capital gains up to that date. So for individual shareholders, buy and hold works best if you live to Methuselah age.

Companies, however, do not suffer from mortality. If you hold your investments through a company you control through fixed value preferred shares and set it up so that the common shares are held by a trust for your children or grandchildren , you avoid paying capital gains tax on your death. A good tax professional can help you.

The power of long-term compounding and the fact that it is counter-intuitive is at the heart of why some investors become very wealthy over time – and most don’t.

RB (Biff) Matthews is Chairman and Doug McCutcheon is President of Longview Asset Management Ltd., a Toronto-based investment management company.

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