Rule Breaker Portfolio All About Compounding

With the markets closed and the nation in mourning, we run this classic article from 1998. It discusses the power of compounding over time, from compounding interest to compounding knowledge to compounding population growth.

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By Selena Maranjian (TMF Selena)
September 12, 2001

[The financial markets are closed today, as America comes to grips with the devastation in New York City's financial district and at the Pentagon in Washington. Follow this link for more information and ways you can help those in need. The story below originally ran May 21, 1998.]

"The greatest blunders, like the thickest ropes, are often compounded of a multitude of strands. Take the rope apart, separate it into the small threads that compose it, and you can break them one by one. You think, "That is all there was!" But twist them all together and you have something tremendous."

-- Victor Hugo, Les Mis�rables (1862)

Compounding. You're likely to read a lot about it here at The Motley Fool. After all, the magic of compounding is at the heart of Foolish investing. Consider what happens to $1,000 growing at the stock market's average return of 11% per year. In the first year, it gains $110, and ends the year totaling $1,110. In year two, it gains $122. Year five, $167. Year 16, $526. Year 22, $984. The remarkable thing occurring is that without your doing anything to your pile of wealth, it's growing -- by an increasing amount each year.

That last bit there is the essence of compounding. In year 45, you gain $10,854 -- roughly 100 times your gain in the first year. And a mere 22 years after that, you'll gain ten times that, $107,822, bringing your bundle of wealth to an amazing total of $1,088,027. All of this from an initial investment of $1,000 that kept growing by increasing amounts each year.

Of course, if you began at age 45, you'd be 111 by the time you accumulated a million bucks with this system. At that age, you might have trouble climbing a stairway to paradise. Consider this possibility, though. If you invest the single $1,000 in an S&P 500 index fund the year a child is born and over the years it continues returning an average of 11% per year, that child will eventually have about a million dollars with which to retire. Invest the money now for a great grandchild years away from being born and the growth will be more impressive. The tot can end up with millions when she graduates from college.

What a legacy that could be. You might be the one who starts an incredible tradition in your family -- investing two generations ahead. Wouldn't it be great if everyone in your family inherits a portfolio worth many millions upon adulthood? And if they continue the tradition, socking away a mere $1,000 (or really, its future equivalent) for their own descendants, all your progeny would be set for life. The tradition would have to start somewhere, though -- so maybe it could start with you. You'd end up being, as David Gardner once put it, your family's "most beloved ancestor."

In the scenario described above, there are several forms of compounding at work -- not just the one we're used to thinking about. Sure, the money is compounding. But so is the financial security of your descendants. Awareness of the power of investing will also multiply. More and more people will be aware of how to put money to work effectively. Perhaps many of your great grandchildren will be so impressed with your benevolent thoughts and actions that their own character will be influenced for the better. Perhaps one of them will end up choosing a path in life that significantly improves life on our planet -- all because of what you did long ago. Perhaps many of these youngsters will grow into exceedingly magnanimous people, inspiring friends and acquaintances to be generous, as well. The compounding possibilities are endless. One good deed of yours could be rippling and multiplying across humankind eons after your body has turned to dust.

Clearly, lots of things compound besides money. Knowledge, for one. The more you know, the more you're able to learn -- the more hooks you have, on which to hang additional bits of information, eventually forming an enormous web of smarts. Once you learn a little about Ancient Rome, for example, you can read novels set there and enjoy them all the more, connecting snippets from the books with your understanding of how that society worked. (We pause now for a book recommendation: Check out the terrific and captivating historical mysteries of Lindsey Davis; the series begins with Silver Pigs.) Plus, you'll be adding to your existing knowledge with new information from the books (such as the fact that people often peed in laundry establishments, as clothes in those days were cleaned with urine.) (Yeah, yeah, it's gross; but hey -- it's history!)

Remember that shampoo commercial, which urged you to tell two friends (and then they'll tell two friends, and so on and so on...)? It works with Foolishness, too. Try it -- tell two un-Foolish people about how important it is to take control of your financial future. If they tell two people and the process keeps repeating, after only about 29 iterations, everyone in the United States will be on their way to becoming successful individual investors. After 33 iterations, everyone on the planet will have been reached. Considering that the average American household carries some $7,000 in debt on its credit cards (per a 1997 Consumer Federation study), spreading the Foolish message (perhaps with a nudge toward our Personal Finance area) can make quite a difference.

Compounding isn't necessarily good, though. Consider epidemics, like cholera, malaria, and AIDS. When you have more and more people infecting each other, you're looking at the evil, dark side of compounding. There's a financial dark side, as well -- if you get too Wise. Imagine becoming a more and more manic day-trader, jumping in and out of stocks every day, trading options, dabbling in futures, snapping up penny stocks, and looking for images of chickens in graphs of stock prices. Not only is your nest egg likely to suffer, you'll also end up spending less time with friends and family. Heck -- you could even end up with fewer friends and family members, especially if you've been passing on hot commodities tips.

Another example of compounding is population growth. Two people give birth to two or more people, who each generate more people, and so on and so on. If you stop to think about it, perhaps it's not so odd that a guy like Warren Buffett has as a primary concern overpopulation. His life has been dedicated to compounding wealth. Compounding is a concept that's at the core of his way of thinking. How natural that when he looks at the world, he sees compounding occurring.

Even language can compound. Consider the words of Virginia Woolf in Orlando, describing the nineteenth century:

"Men felt a chill in their hearts; a damp in their minds. In a desperate effort to snuggle their feelings into some sort of warmth, one subterfuge was tried after another... sentences swelled, adjectives multiplied, lyrics became epics."

Fool on!

--Selena Maranjian

Rule Breaker Portfolio

9/12/01 as of ~8:30:00 PM EDT

Ticker Company Price
Daily Price
% Change
AMGNAMGEN INCUnchg.Unchg.64.13
EBAYEBAY INCUnchg.Unchg.54.57

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Rule Breaker0.00%3.38%(4.58%)(5.52%)293.02%21.24%
S&P 5000.00%0.62%(3.62%)(17.25%)138.34%13.00%
S&P 500 (DA)0.00%0.59%(3.42%)(16.44%)152.59%13.92%

Our overall return stats understate the portfolio's actual returns; here's why. See the internal rate of return below for an accurate statement of our annualized returns.

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (8/5/1994)
Rule Breaker27.37%
vs. S&P 50010.31%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *

Trade Date # Shares Ticker Total Cost Current Value Total Gain *

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.

The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.