This is How Compounding works - MUST WATCH | Mohnish Pabrai | Stocks | Investment
Summary
TLDRThe 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
- ๐งฎ **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.
- ๐ **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.
- ๐๏ธ **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.
- ๐ธ **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.
- ๐ด **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.
- ๐ **Educational Importance**: The speaker emphasizes the importance of being able to perform compounding calculations mentally, as it has significant practical implications.
- ๐จโ๐ผ **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.
- ๐ผ **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.
- ๐ง **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.
- ๐ซ **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.
- ๐ **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
๐ 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.
๐ผ 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.
๐ 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.
Mindmap
Keywords
๐กCompounding
๐กInterest Rates
๐กRule of 72
๐กWarren Buffett
๐กManhattan
๐กInvestment Officer
๐กRetirement Account
๐กMinimum Wage Job
๐กIRA (Individual Retirement Account)
๐ก401(k)
๐กTime Value of Money
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
[Music]
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