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The Joys of Compounding Interest

The Joys of Compounding Interest By Arthur Q. Johnson, CFA

American statesman and founding father, Benjamin Franklin, wrote in The Way to Wealth, “Remember that time is money and that money is of a prolific generating nature. The more there is of it the more it produces every turning, so that the profits rise quicker and quicker. Waste neither time nor money, but make the best use of both. For industry and patience are the surest means of plenty.” Mr. Franklin was well aware of the positive impact that compounded interest has on a dollar saved and his net worth reflected as much when he retired from the publishing trade at the age of forty-two to focus on politics and diplomacy in the mid-1700s.

In 2006, the Internal Revenue Service allowed a maximum contribution of $4,000 ($5,000 if you are age 50 or older) to an Individual Retirement Account (IRA) which is a trust or a custodial account established for the exclusive benefit of the investor or his or her beneficiaries that defers the taxation of dividends, interest and capital gains until distributed as early as age 59 ½ and no later than 70 ½. Assuming that a family or individual is capable of saving $4,000 in each of the next twenty years beginning in 2007 in an IRA account that provides an annualized rate of return of 7% (the average ten year compounded rate of return of the Standard & Poor’s 500 Index since 1997). From year 2027 until 2047 should the family or individual decide not to contribute another dollar in the IRA at the same 7% rate of return, their initial investment of $80,000 will grow more than six-fold to $575,000 by the end of the fortieth year. The earlier an investor contributes to an IRA the greater the magnitude of the growth of those assets over longer periods of time.

For taxable accounts, the power of compounding applies to expenses, primarily taxation, as well as profits. A dollar invested in an asset that doubles every year for eleven years is worth $2,048 and if sold at the end of year eleven triggers a long-term capital gain of $2,047. At a 15 percent tax rate, the investor owes the government $307 leaving $1,741, which is the same as getting a 97% percent return, tax free for eleven years. If the same dollar is doubled every year and then sold at the end of each year for a maximum short term capital gain tax rate of 35%, the investor would be left with $194.44 at the end of year eleven resulting in a 61.5% annualized rate of return after taxes. Due to the annual taxation of capital gains, the investor is not doubling his money but increasing it by a factor of 1.65 after taxes.

In 1964 Warren Buffett, current CEO of Berkshire Hathaway and arguably one of the most successful investors of our time, wrote in a letter to his limited partners that Francis I of France had paid 4,000 ecus (approximately $20,000) in 1540 for Leonardo da Vinci’s Mona Lisa. If Francis had invested that same amount in a 6% after-tax investment, his estate would have been worth more than $1 quadrillion or over 3,000 times the national debt of France at that time. Warren went on to write, “I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment.”

Benjamin Graham, author of Security Analysis and The Intelligent Investor wrote, “An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory rate of return. Operations not meeting these requirements are speculative.” In other words, “the first step in making money is not losing money.” More specifically, time invested in the common stock of quality businesses at reasonable prices, rather than focusing on market timing or short term trading, has typically provided for satisfactory rates of return due to the lower expense of taxation on assets that are held for at least one year or longer.

Arthur Q. Johnson is Portfolio Manager for the Mundoval Capital Management, a no-load Global Value Equity mutual fund.