There's a famous quote attributed to Albert Einstein about the power of compounding. It goes as follows:
Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.
There's actually no evidence of Einstein uttering these words. However, that doesn't mean the statement is any less true.
Compounding, which is what happens when you earn interest on top of interest, really is a wonder and it is easy to demonstrate why.
The magic of compounding
Were I to offer you the chance to choose $1 million of cold hard cash right now or $1 doubled each day for a month, it would seem that the cash up front would be the best option.
However, because of compounding, accepting the alternative would certainly be the way to go.
And not by a fine margin. Not at all. Yes, the first option gets you a cool million dollars, but the latter gets you a place on the Rich List.
But it takes time. If you double $1 each day, it becomes $2 the first day, then $4 the next, then $8 the third day, and so on and so on. By the end of the first week, you have $128 in your pocket.
At this point, it looks like we've given up our Ferrari for the equivalent of a nice dinner for two.
But don't be fooled, compounding is just warming up. A week later, the doubling has taken us to $16,384. Now things are getting interesting!
Fast forward another week and our money has compounded its way to approximately $2.1 million. That's more than double the upfront offer we received and we're only three weeks in!
Finally, once we get to the 30-day mark, we have seen our money increase to almost $1.1 billion, cementing our position on the Rich List.
What can you learn from this?
Unfortunately, you're not going to double your money every day by investing in ASX shares.
However, you can still grow your wealth materially over the long term thanks to compounding.
Over the last 30 years, the Australian share market has generated a total return of 9.6% per annum for investors.
If you had invested $12,000 a year or $1,000 a month into ASX shares and matched this return, you would have seen your portfolio grow in value to be worth just over $2 million today.
It might not be $1 billion but it certainly would be very welcome in my bank account!
