This is How Compounding works - MUST WATCH | Mohnish Pabrai | Stocks | Investment

Summary

The speaker emphasizes the profound impact of compound interest, illustrating its power with historical examples and math calculations. They recount Warren Buffett's story of Manhattan's sale by the Min Indians for $24, demonstrating how that amount could have grown to trillions with a 7% annual return. The talk also touches on the importance of starting to invest early, using the example of a librarian who saved $4 million and the potential of an 18-year-old saving a small amount annually. The message is clear: understanding and leveraging compounding can lead to significant wealth accumulation over time.

Takeaways

• 🧮 **Understanding Compounding**: Einstein considered compounding as the eighth wonder of the world, highlighting the importance of grasping the power of compound interest and its mathematical implications.
• 📈 **Rule of 72**: The rule of 72 is a simple way to estimate how many years it takes for an investment to double, given a fixed annual rate of interest.
• 🏖️ **Historical Investment Example**: Warren Buffett used the example of the sale of Manhattan by Native Americans to illustrate the potential of compounding over time, had the $24 been invested at 7% annually.
• 💸 **Impact of Time and Rate**: Two key factors in compounding are the length of time and the rate of growth. Even a modest rate can lead to significant results over a long period.
• 👴 **Longevity and Compounding**: The longer one can compound their investments, the greater the potential wealth accumulation, which is why Buffett values longevity in the context of investment growth.
• 🎓 **Educational Importance**: The speaker emphasizes the importance of being able to perform compounding calculations mentally, as it has significant practical implications.
• 👨‍💼 **Real-life Story**: The story of a librarian who left a sizable donation upon his death demonstrates the power of consistent saving and compounding, even on a modest income.
• 💼 **Career Earnings vs. Compounding**: A person starting with a minimum wage job but saving and investing can end up with a substantial net worth due to the effects of compounding over 50 years.
• 👧 **Youth and Investing**: Starting to save and invest at a young age, such as during an internship, can lead to a substantial accumulation of wealth by retirement age due to the magic of compounding.
• 🚫 **Avoid Early Withdrawals**: The script advises against taking early withdrawals from retirement accounts like 401(k)s or IRAs, as it can lead to significant value destruction over time.
• 📊 **Mathematical Fluency**: Having fluency in the mathematical concepts related to compounding is crucial for understanding and utilizing its power effectively.

Q & A

What did Einstein reportedly call compounding?

Einstein is said to have called compounding the eighth wonder of the world, highlighting its significant impact on growth over time.

Why is it advantageous to understand the power of compounding?

Understanding the power of compounding is advantageous because it allows individuals to perform mental calculations related to financial growth, which can lead to better investment decisions and wealth accumulation.

What historical example was used to illustrate the power of compounding in the script?

The script uses the example of the sale of Manhattan by the Min Indians to the Dutch for $24 in 1626, and how that amount could have grown to trillions if invested at a 7% annual interest rate.

According to the script, what is the estimated wealth of the entire planet?

The script estimates the entire wealth of the planet to be 300 trillion dollars.

What is the estimated wealth of the United States mentioned in the script?

The script estimates the wealth of the United States to be 80 trillion dollars.

What is the Rule of 72, and how is it used in the script?

The Rule of 72 is a mathematical rule used to estimate the number of years required to double the investment at a given annual rate of return. In the script, it is used to demonstrate how the $24 invested at 7% interest rate would grow over time.

What is the significance of the number 2^10 in the script's explanation of compounding?

The number 2^10, which equals 1024, is used in the script to illustrate the concept of exponential growth, showing that an investment would increase by a factor of 1,024 in 100 years if it were to double every 10 years at a 7% interest rate.

How much would the $24 invested in 1626 be worth today if it had been compounded at 7% annually?

According to the script, if the $24 from 1626 had been invested at a 7% annual interest rate, it would be worth approximately 12 trillion dollars today.

What is the importance of starting to invest at a young age, as illustrated by the script?

The script emphasizes the importance of starting to invest at a young age because the longer the investment has to grow, the more significant the compounding effect, leading to substantial wealth accumulation over time.

What is the significance of the librarian's story mentioned in the script?

The story of the librarian who left $4 million to the college where he worked is significant because it demonstrates the power of consistent saving and investing over time, even with a modest income.

How does Warren Buffett view the concept of compounding?

Warren Buffett views compounding as a critical element in wealth accumulation. He is known to have understood the concept at a young age and has used it to build his wealth over many decades.

Outlines

00:00

📈 The Power of Compounding Interest

The first paragraph discusses the concept of compounding interest, highlighting its significance as 'the eighth wonder of the world' according to Einstein. It emphasizes the importance of understanding compounding for financial growth. The speaker uses a historical example from Warren Buffett's letter to illustrate the potential of compounding: if the Native Americans had invested the $24 they received for Manhattan at a 7% annual interest rate, it would have grown to over 12 trillion by 2025. This example showcases the exponential growth of money over time and the impact of compounding on investment returns.

05:00

💼 The Impact of Time and Growth Rate on Wealth

The second paragraph delves into the factors contributing to the growth of wealth through compounding: the length of time and the growth rate. It uses the example of a librarian who saved $4 million, demonstrating the power of consistent saving and investing over time. The speaker then creates a hypothetical scenario of an 18-year-old earning minimum wage, saving 10% of their income, and receiving a 7% return on investment. Over 50 years, this would result in over a million dollars. The paragraph underscores the importance of starting to invest early and the significant impact of compounding on long-term savings.

10:02

🚀 Early Investing and Its Long-Term Benefits

The third paragraph focuses on the benefits of early investing, using the speaker's daughter's experience as an example. After earning $5,000 from an internship, she opened an IRA and invested the money, which could potentially grow to $5 million by the time she is 68, assuming a 15% annual return. The speaker emphasizes the importance of the 'runway' or the length of time available for investments to grow, and how Warren Buffett's long-term approach to compounding has contributed to his wealth. The paragraph concludes with a caution against withdrawing from retirement accounts prematurely, highlighting the significant value destruction that can occur.

Keywords

💡Compounding

Compounding is the concept where earnings from an investment are reinvested to generate additional earnings. In the video, it is described as 'the eighth wonder of the world' by Einstein, highlighting its significance. The script uses the example of $24 invested at 7% interest rate over centuries to illustrate how it can grow to trillions due to compounding, emphasizing its power in wealth accumulation.

💡Interest Rates

Interest rates are the percentage at which borrowing or lending money is done. In the context of the video, interest rates are crucial for compounding, as they determine the growth rate of an investment. The script mentions a 7% interest rate as an example to demonstrate the exponential growth of an initial investment over time.

💡Rule of 72

The Rule of 72 is a simple formula used to estimate the number of years required to double the invested money at a given annual rate of return. The video script explains this rule by dividing 72 by the interest rate to find out how many years it takes for the money to double, which is instrumental in understanding the growth of investments over time.

💡Warren Buffett

Warren Buffett is a renowned investor and the CEO of Berkshire Hathaway. The video script references a letter he wrote to his investors in the 1950s, using the historical example of the sale of Manhattan to illustrate the power of compounding. Buffett's investment philosophy and his understanding of compounding are central to the video's message.

💡Manhattan

Manhattan is used in the video as a historical example to demonstrate the missed opportunity of the Native Americans who sold the island for $24. The video contrasts the initial sale price with the potential value had they invested that money and let it compound over centuries, showcasing the dramatic impact of compounding.

💡Investment Officer

An investment officer is a hypothetical character in the script who represents someone responsible for managing investments. The video speculates on what might have happened if the Native Americans had an investment officer who understood compounding and could have invested the $24 wisely.

💡Retirement Account

A retirement account is a savings plan for long-term goals, such as retirement. The script talks about an 18-year-old saving a portion of his income into a retirement account, which grows significantly due to compounding. It illustrates the importance of starting to save early for retirement.

💡Minimum Wage Job

A minimum wage job refers to employment where the worker is paid at least the minimum wage set by law. The video uses the example of an 18-year-old with a minimum wage job who saves a portion of his income, demonstrating that even with a modest income, significant wealth can be accumulated through compounding.

💡IRA (Individual Retirement Account)

An IRA is a tax-advantaged investment account designed for retirement savings. The video script mentions an IRA as a vehicle for saving and investing, emphasizing the benefits of tax advantages and compounding for long-term growth.

💡401(k)

A 401(k) is a retirement savings plan sponsored by many employers in the United States. The video script cautions against withdrawing money from a 401(k) to go on vacation, highlighting the long-term value destruction that can occur when retirement funds are accessed prematurely.

💡Time Value of Money

The time value of money is the concept that a dollar today is worth more than a dollar in the future due to its potential earning capacity. The video script emphasizes this by illustrating how the early investment and compounding of a small amount of money can lead to substantial wealth over time.

Highlights

Einstein considered compounding as the eighth wonder of the world.

Understanding the power of compounding is a huge advantage.

Warren Buffett highlighted the story of the sale of Manhattan in 1626 for $24.

The concept of compounding can turn a small investment into a fortune over time.

The Rule of 72 is a simple way to estimate how long it takes for an investment to double.

An investment of $24 in 1626, compounded at 7%, would be worth over 12 trillion today.

The value of Manhattan's land is unlikely to be worth 15% of the total wealth of the United States.

The importance of starting to invest early and the impact it has on wealth accumulation.

An example of a middle-class librarian who managed to save $4 million through compounding.

The example of an 18-year-old saving $1,500 annually and growing it to over a million by the age of 68.

The significance of a modest 2% annual income increase and its impact on savings over time.

The story of Warren Buffett predicting his future wealth at the age of 24.

The importance of not withdrawing from retirement accounts early.

The concept of the 'runway' in investing and its relation to the time it takes for investments to double.

Warren Buffett's wish to live as long as possible to continue compounding his wealth.

Transcripts

Einstein uh Einstein said that

compounding was the eighth wonder of the

world and um and it is so so we all we

all learn about interest rates and

growth of things over time and different

things like that but but I think that is

it is a huge Advantage if you can

understand the power of compounding and

if you can do a bunch of math related to

compounding in your head so what I'm

going to do is just kind of throw out

some uh some terms and some of the math

actually that we're going to do I've not

done myself so I'll be doing it on the

Fly uh which would be kind of fun so uh

so I I'll take one example from a letter

Warren Buffett wrote to his investors in

the 1950s I think it was like 58 or 59

uh and he said that the uh the Indians

uh the American Indians who were based

in in Manhattan what was Manhattan in

New York in 1626 it's rumored uh that

they sold the island Dom Manhattan to

the Dutch for

$24 uh that was the the the sale price

and of course when people hear that they

say you know $24 you know the Indians

got taken for a ride and and such but uh

let's say the menu Indians I think they

were the Min Indians who did that let's

say the Min Indians had some kind of

trust officer or investment officer in

1626 and uh um the Dutch came to him and

that this deal was on the table of $24

and uh um you could sell this

undeveloped Island um so he would he

would probably think about what are my

alternative uses uh if we don't do the

deal or what else can we do and um he'd

probably run some numbers and he would

have probably concluded there was a

fantastic deal and why is it a fantastic

deal so let's say that $24 in

1626 uh the the Indians were able to

take that and invest it at something

like 7% a year for example what would

that $24 be today if if it were invested

at 7% so uh let's do the math uh without

any pencil of paper so we we have

something known as the rule of 72 which

some of you may be familiar with which

is that you know if I have a 7% interest

rate I can take 72 divide by 7 it's

approximately 10 which says that in 10

years at a 7% interest rate the money

would double okay so basically if in

1626 they sold for $24 in 1636 they

would have $48 in 1646 they'd have $96

and so on it keep doubling every 10

years so basically if you take a

100-year period uh you get 2 to the^ 10

uh 2 the^ 10 is a good number to know

it's

1,24 and let's throw away the 24 because

that makes the math a little harder so

we have 1,000 so in a 100 years whatever

they got increases a thousand times so

if in 1626 they got 24 in 1724 they have

24,000 okay and in 8 18 1823 or whatever

they have or

1825 uh they have 24 million and by 1925

they have uh 24 billion and uh 2025

which is 9 years from now uh they have

24 trillion right now we are about 10

years away from the the 24 trillion and

10 years of the double so today they

would have about 12 trillion right so we

we did the math without a calculator

which is great well done Mish okay and

and the thing is you can do the math

yourself also without and the important

thing with compounding is to have the

fluency to do it in your head because

it's very important to be able to do

this in your head because it has huge

impacts so $24 in 1626 7% compounded is

today 12 trillion so what is the value

of undeveloped so let's say Manhattan

today the land of Manhattan if it if had

if had no buildings on it and or or

let's say let's put it this way if I

were to go and offer to buy everything

in Manhattan and then I subtract the

cost of the buildings which is the land

value because of undeveloped land would

the land be at 12 trillion right and the

answer to that also is very simple so

the entire wealth of the planet every

man woman child everything they own is

300 trillion uh the entire wealth of the

United States is 80 trillion um it is

very unlikely that something like 15% of

that 80 trillion is just Manhattan land

uh that's that's that's a and in fact I

think Warren calculated that I think he

calculated in the 1960 or something it

was 12 and A2 or 12 billion or something

actually was less than 12 billi

something 10 billion so you might get to

a few hundred billion maybe in value uh

on a good day so the Indians um the

Indians basically uh sold

Manhattan uh at a at a rate where if

they had held today they had held that

land till today and they did the deal

today they would have basically lost uh

several trillion in value uh by by not

doing the deal now of course the the

trust Office of the menu Indians uh was

an idiot in terms of investing and he

didn't get them to 12 trillion but

that's a different story we'll get to

that later uh so so how do we get

$24 to become 12 trillion right so let's

break that apart let's break that apart

there are two factors

that lead to the 12 trillion the first

factor is the length of time okay length

of time is a very important variable in

how much your money grows and the second

factor is the rate at which it grows

right and what we found is that even at

a not a very high rate 7% is actually

below the S&P is done you get some

astounding results now recently I don't

know whether you saw in the news there

was uh there was some uh older gentleman

who passed over away some in some way in

the Northeast he was a librarian uh you

know just middle class librarian all his

life and when he passed away he gave the

college where he worked $4 million um

and everyone was surprised that this guy

who was very much a You Know M middle

class ordinary guy had actually got $4

million saved up and of course these

journalists wrote the article don't know

how to do math and they didn't attend

the lecture that we just having so they

didn't understand kind of how things

work with get get million so let's take

a situation okay so let's say there's an

18-year-old and let's say this

18-year-old has very few skills and he

can only get a minimum wage job right

and so he's making you know something

like 15,000 per year working 2,000 hours

so and let's say for example he's able

to save uh something like 10% maybe hard

but let's say he's living at home Etc

saves 10% of that 15,000 uh before taxes

because you can put in an IRA or

something and so his his actual kind of

uh after tax income might decline by a

th if he's working some place where

there's an employer match some of you

students will get employer matches and

such in retirement accounts so you might

have to save less to get more so if this

person is 18 years old saves

$1,500 and let's say he keeps putting uh

the, 1500 every year into a retirement

account and let's say for example that

uh he gets that something like a 7%

return on that money and let's say that

his income goes up very modestly like

his income is only going up by 2% a year

and when it goes up by 2% year his

savings go up by 2% a year so instead of

saving 1,500 next year he saves

$1,530 so it goes up very slowly and

when he when he retires 50 years from

now which is at the age of

68 uh he is at that point 50 years later

making less than 50,000 a year didn't

have any significant growth in income uh

just barely kept up with inflation and

such what would that person have at the

age of 68 well let me make it easy for

you um the first year the first year

when he saves the 1500 he's got 50 years

we know it's 7% we know it doubles every

10 years we know it's 2 to the^ of 5 we

know 2 to the^ 5 is 32 and we know what,

1500 time 32 is so he''s got uh

48,000 right so the first 80 what he

saved 18 at the age of 68 is 48,000 age

of 19 uh maybe somewhere similar to that

but you you get the point as you go on

the end result is to make it simpler for

you uh is a little over a million

dollars okay so the LI librarian is not

making 15,000 he's got a white colar job

uh he's probably making somewhere less

than 100 and maybe more than 40 or

50,000 somewhere in that range and uh he

paid attention when they were talking

about compounding in math class you know

and um and he if he makes four times

what the guy with the minimum wage makes

without doing anything esoteric he ends

up with a a very significant uh net

worth so so the the the the question is

why why doesn't

everyone end up wealthy when we retire

because there's not much required to

become wealthy you just have to follow a

certain game plan and you'll be there

and in fact at the 68 uh the guy was

making less than 50,000 he he could

start withdrawing uh 50,000 or more per

year from that account and would Outlast

the rest of his life um because he'd

have a 5% withdrawal rate and he's got a

7% uh earnings rate so that the the

money would actually keep growing he'd

probably end up making a $4 million

donation to uh another another school or

something so compounding is a very

important uh element to understand and

again what matters is it makes a huge

difference

if that person starts at the age of 18

versus 28 huge difference and um my

daughter my my younger daughter uh last

year uh she interned at uh at a place

and she got paid like uh close to $5,000

during the internship no expenses and

such so the money was just sitting there

so I said you know you can open an IRA

and uh so I I uh got her to open an IRA

and then I said you know if you if you

trust me you can give me power of

attorney and I can invest the money for

you and one time she was flying back

from New York she was very tired and I

just told you know that $5,000 you gave

me at the age of 18 um it's um uh I put

it into one stock you know because you

know we can uh we can take some risk

because you 18 you don't need the money

and um probably that that stock doubles

or triples in the next two three years

because it's my best stock pick and uh

so I said you know let's say doesn't

even double or triple let's say it you

know goes at 15% a year or something uh

so 15% R of 72 every 5 years things

double right and I ran the math for her

and I said what does the 5,000 become at

the age of 68 right so you got 50 years

to the^ 10 uh so you got uh 10 uh 10

doubles you got a th uh you get to a,

Times the 5,000 uh which is 5 million so

I said maachi you know you you worked

one summer and in the age of 68 you'll

have 5 million from the summer work but

then the next summer you're going to

work again and uh that'll become 5

million at the age of 69 and at some

point you're going to graduate and uh

you might make more than 5,000 in a year

and you might actually save a few

thousand and um I said what what's your

net worth at the age of 68 and I gave

her some number and by it was like 2: in

the morning I picked her from the

airport and she was asleep and she was

wide awake you know oh like how did that

happen you know and and what's going on

like you know very very very focused and

uh so the the thing is it's it's the two

pieces the length of the runway is

really important right so 50 years

number of doubles it's all about the

number of doubles this is how Buffett

thinks about it how long does they take

things to double so if you ask Warren

Buffett Mr Buffett I'm the genie from

Aladdin you can have any wish you want

what would you like you know so you know

what he would say he says I only want

one wish which is that when I'm dead and

they look at me they say man he was old

okay

so so he just wants to not die for as

long as possible and it's not like he

loves all of us on planet Earth is why

he doesn't want to die he wants to

compound and he wants to keep

compounding for as long as he can and I

think in his case in his case he's

86 and he started his compounding

Journey at the age of 11 and he actually

understood compounding I think age age

of nine or 10 and I think at 24 or

something he told his wife that we are

going to be wealthy beyond our dreams

we're going to have more money then we

won't we won't know what to do with it

and so we got a plan for like you know

what are we going to do with all this

extra cash and his wife thought you know

this guy is you know we got we can we I

want to buy a house we don't have money

to buy a house he thinks we're going to

get super wealthy what's going on and of

course they did so so compounding is a

very important element no matter what

your profession or or uh you know

calling in life ends up being it's very

important to have the fluency in math

very important to understand the con

concept of a Runway and the length time

it takes to double and compounding rate

and don't take the retirement account of

401 k ira pull out the money and go on

vacation you know uh the the the time

value destruction of that is huge

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