Compound Interest May Not Be Einstein’s Eighth Wonder, But It Is A Powerful Tool For Investors
If you invest 10 percent money for five years, you will multiply your wealth 1.6 times.
If you invest your capital at this rate for 10 times longer (50 years), you will not multiply your wealth by 16 times.
You will multiply it by more than 117 times.
Does this seem surprising to you? It should be, because exponential growth (also known as compound growth) is difficult for the human mind to grasp.
Understanding this, however, is the source of a successful investment. Albert Einstein is said to have said: “Compound interest is the eighth wonder of the world. Whoever understands it wins it; whoever does not, pays for it.
Back to basics. Investing is simply setting aside a sum of money for a period of time in order to get a lot more money, in real terms, in the future.
Your success as an investor depends on two things:
- your net return on investment over time;
- the length of time you stay invested.
What determines your long-term rate of return? Studies have shown that by far the most important factor is which asset class you invest in. Investing in a portfolio of growing companies, through ownership of 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 teaches us that over 20 years or more, assuming inflation is reasonably subdued, your average annual return on an investment in a portfolio of listed companies (stocks) is likely to be between 7-10%, before taxes.
Any tax paid on your return on investment will of course reduce this amount. This is one of the few certainties when it comes to investing. Investors are not taxed on their capital gains until the asset is sold. So there is a huge advantage in holding each of your investments for the long term. As Warren Buffett put it, “Investors who pay taxes will realize a much larger sum from a single investment that consists internally at a given rate than from a succession of investments that consist of the same. rate. “
Almost everyone focuses more on the rate of return than on how long their capital will be invested. To benefit from compound growth, however, it is essential to consider both factors – and your ability to change the investment period is far greater than your ability to change the rate of return over the long term. “Buy well and hold on” is a slogan adopted by some of the world’s most successful investors.
This long-term approach explains why nearly all of the world’s great family fortunes (think Buffett, Gates, Thomson) were created by owning shares in a growing company for many decades, allowing their value to accumulate. over time. on a pre-tax basis.
However, there is a limit to the length of time during which individuals can build up their wealth tax-free. When you die, you are deemed to have disposed of your investments for tax purposes. Therefore, your estate is taxed on your capital gains until that date. So, for individual shareholders, buying and holding works best if you live to the Methuselah Age.
Businesses, however, do not suffer from mortality. If you own your investments through a corporation that you control using fixed-value preferred shares and you configure it 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 accountant can help.
The power of long-term capitalization and the fact that it is counterintuitive are at the heart of the reasons some investors get very wealthy over time – and most don’t.
RB (Biff) Matthews is President and Doug McCutcheon is President of Longview Asset Management Ltd., a Toronto-based investment management firm.