Still More Compound Interest

Friday morning update: The market is down a bit as I write this. Presumably, it will just bounce back quickly as it “always” does (always, if you’ve only been doing this a few years). But it’s interesting, if one is looking for “signs,” that the savviest firm on Wall Street, Goldman Sachs, recently sold shares in itself for the first time in its history. Also that Treasury Secretary Rubin is leaving — not because he expects trouble, but because, well, when things are this good, it’s a good time to get out. And that Jim Cramer’s thestreet.com was brought public at an absurd $400+million valuation — and promptly tripled. The casino is at full frenzy. One day there will be a hangover.

Still, over the long run, a steady program of periodic investments in stocks should serve you well. (Usually best: no-load, low-expense, tax-efficient index funds.)

Which, of course, brings me back to the power of compounding.

Jarett D. Chaiken:

“While I’ve enjoyed reading about compound interest several times in the last 2 weeks (playing with big numbers is admittedly fun), and your point is clearly to show the power of compound interest. I’m a little disappointed that you have not pointed out some of the obvious flaws in your calculations.

“First, not once were the compound tax consequences mentioned. If you put $0.01 in the bank 1,000 years ago, and paid taxes on the dividends as you received them, what drag would that have on my return?”

No drag at all in the U.S. from 1776 to 1913, when (if memory serves, and it may not) the first income tax was enacted. But as to the other 863 years, I am less certain. Then again, the kinds of interest rates we were using in our examples — 2% and 5% — were low enough that we might have considered them “after-tax” rates, even in years when there was an income tax.

“Second, If I had put $0.01 in a bank 1000 years ago, it would be worth nothing today, since there are to my knowledge no investment vehicles that have been around that long (or governments for that matter) so when is the right time to remove my money from a failing bank?”

Ah, there’s the rub. But as optimists, going forward, might we hope there could be institutions and economies that do not fail? Might we, as a species, be getting better at this game of civilization and commerce? Maybe, maybe not. Of course, few if any of us will live for 1,000 years. (Even that, I think, may one day be possible, if not in quite the corporeal form we live today.) So this hypothetical millennial compounding is almost as silly looking forward as it is looking back. But as Jarett says, it’s fun.

“Third, and maybe most importantly, if I had put some amount of money into a bank 1000 years ago, that has been paying some rate that would make my investment worth $1 trillion, how could the bank afford to pay me my interest? Finding places to put $1 trillion so that the bank can earn any money would be near impossible, and probably bankrupt the bank; and what happens when I go to withdraw this money and suddenly there is an additional trillion dollars entering the economy, what would that do to the CPI?”

Well, that’s third and maybe least important. The thought being that if people 1,000 years ago had invested for the future . . . and if countries and economies had arranged themselves in such a way as to make that investment productive, and managed better to avert war and withstand disasters like the plague . . . then the whole world might be vastly more wealthy and prosperous today, with trillionaires as common as billionaires.

Imagine the difference between a country like America, that has managed to attract and respect capital — financial (e.g., venture capital), infrastructural (e.g., our Interstate Highway system), and intellectual (e.g., our superb system of higher education, the hundreds of billions in accumulated R&D) — and, say, Uganda or Bangladesh. The American, capitalist model, with great good luck, might actually just keep growing for centuries. It’s possible. In Uganda or Bangladesh, until things change, you could wait 1,000 years and still be at subsistence.

In those instances where people have invested for the long-term, the results have indeed been good. The most famous is Ben Franklin. At his death he left a thousand pounds each to the cities of Boston and Philadelphia. The money was to be reinvested for a century — with spectacular results I have written of elsewhere (the specifics of which I do not have handy here at 37,000 feet, let alone in my near 1,000-year-old brain).

“I believe that compound interest is very powerful, and putting away money sooner is definitely better than doing it later, but using 1000 years as a reference seems to me to be very unrealistic. Better to show the (much more modest) power of what $1000 can do over 100 years in a Roth IRA starting today so your great-grandchildren (whom you might actually meet) can enjoy your success, than to fantasize about what one of your ancestors living in Rome 1000 years ago did with his winnings at the Coliseum.”

I’ll buy that. Well, said.

Coming soon: Chapter 9