An Unbelievable Wealth Generating Tool:
The Power of Compounding
Warren Buffett once said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” This article focuses on the last element of Buffet’s quote, specifically why the power of compounding plays such a critical role when investing – and how it can help you grow your wealth by having a portfolio that pays you!
What is Compounding?
Compounding is a powerful investment concept that involves earning a return on your original investment, reinvesting the returns, and then receiving returns on the original investment and the returns made. In other words, your money is making money that is making more money.
This is why many experts describe the compounding process as a “snowball effect.” As your wealth grows, your returns build more power and momentum to grow more rapidly, like a snowball rolling down a mountain.
Why is Compounding Important to Understand – Two Scenarios
One way to think about the power of compounding is actually through the opposite lens of what you would think – debt.
Why do so many consumers find it hard to get out of credit card debt? One of the main reasons is that even if they cut the cards up and stopped spending on them, the outstanding balance still grows unless it is paid down. Why? You guessed it because there is interest – often annualized to 20% – that compounds and gets added to the balance. It is also a snowball, but helping credit card companies grow their wealth.
For example, a $10,000 balance on a credit card with a 20% annualized interest rate, making minimum payments, will take 19 years and 9 months to pay off. The total one would pay back over that time would be just over $22,000. And the worst part is, the credit card companies did not have to do anything.
Now, if compounding is such a powerful concept and used by credit card companies to generate income, can it help you grow your wealth like Buffett? The simple answer is yes, and here is how it can work for you.
Let’s say you have saved up or come across a large sum of money, such as $100,000, and choose to invest rather than spend on a new car or some other liability. By deciding to invest, you have just created the potential of gaining over one million dollars of wealth when combined with the power of compounding.
Using a compound interest calculator online, for a $100,000 initial investment with a 10% interest rate compounding annually, here is what your $100,000 “snowball” will do for you over time:
- 5 Years – $161,051
- 10 Years – $259,374
- 15 Years – $404,555
- 30 Years – $1,378,584
Instead of spending the $100,000 and eliminating the possibility of using the power of compounding, if you were to invest, that money could grow to over one million dollars!
It should be noted this example assumes that the returns are reinvested every year and that the returns are consistent. The intent, however, is to demonstrate the compounding power of returns over time.
So how can you benefit from the power of compounding?
How to Benefit from the Power of Compounding
As you might have guessed, there are many investment vehicles to grow your wealth using the concept of compounding. However, your first step should be speaking with a professional financial advisor before putting your hard-earned money into any investment vehicle. After you have done that, do your research and find what investment vehicles fit your risk profile and financial goals. Here are just a few to consider:
One of the most common and safest ways to invest is through a savings account or bonds. Although interest rates paid for both are typically so small, they would not be the ideal way to take advantage of the power of compounding.
To take advantage of the power of compounding, you could also invest in dividend-paying stocks and automatically reinvest the dividends you receive to purchase more shares of the stock. However, the most significant risk to this strategy is that the underlying stock is subject to any downside risk of the business itself or the broader market.
Another way to benefit from the power of compounding is through investing in real estate. Let’s say you invest passively through a multifamily syndication. You will earn passive income on your initial investment. The income you make can be reinvested into other investments (real estate or others) to have your money (initial investment), making you more money that can be reinvested to make you more money.
Additionally, as the property you invested in appreciates – 7% average per year, which equates to double in value over 10 years – there will be a capital event – sale or refinance. The capital event will allow you to take some or all of your initial investment and reinvest it into another investment, aka “the snowball effect.” This does not consider the several tax advantages you will benefit from investing in real estate.
That is just one example of the compounding power of investing in real estate where your money is now working for you…even when you sleep!
Conclusion
The power of compounding can tremendously impact your ability to generate wealth. When done correctly, it can be a game changer for you.
Diversifying your portfolio into multifamily real estate can be a phenomenal way to take advantage of the power of compounding. However, the key is understanding your financial goals, working with a financial professional, and then getting intentional about your investing.
Do You Want To Learn More
RIZE Equity is a private multifamily investment firm, and we work with accredited investors to help them achieve their long-term investment goals through high-quality multifamily investments in the Southeastern U.S. If you would like to learn more about our investment strategy, we invite you to visit our website at www.rizeequity.com and schedule a free no-obligation appointment with us.
About the author: Sean Cullen is the managing partner and Director of Operations at RIZE Equity Group LLC, a privately held real estate investment company that helps current/former professional athletes, veterans, and business professionals create generational wealth through smart multifamily investments.
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