This article is an excerpt from the Shortform book guide to "Poor Charlie's Almanack" by Charles T. Munger. Shortform has the world's best summaries and analyses of books you should be reading.
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How do you use the power of compounding to build wealth? Can a compounding investment strategy help with taxes?
A passive investment approach utilizes the power of compounding to build wealth. You will earn interest on the money you originally invested plus on the interest you have accumulated. As the pool of money grows, your rate of returns will also grow exponentially. This strategy will also help with taxes because you only have to pay taxes once on the accumulated pool of money as opposed to paying each year and diluting the impact of your capital gains.
Read on to understand more about the power of compounding.
The Power of Compounding
Compounding growth is a formidable force. Growing consistently at a steady-but-not-impressive rate, like 15%, can yield big results over time—such an investment will double every 5 years, and thus grow by 16 times over 20 years.
Taxes make a big difference in compounding growth as well. Compare a passive and active investment approach with the same annual rates of return.
- In the passive approach, you earn 15% per year for 30 years, then liquidate at the end of the period, paying a one-time 35% tax. You’ll have 43x your initial investment at the end.
- In the active approach, you earn 15% per year, but need to pay 35% tax each year due to active trading and creation of capital gains. Here you earn only 9.75% per year; at the end of 30 years, you’d earn only 16.3x your initial investment.
With growth that’s not taxed, you have a difference of 2.6x in the same investment period, despite having the same nominal pre-tax growth per year.
However, there are natural limits to the power of compounding. Because of finite resources, a company or investment cannot grow at the same compounded rate indefinitely (if it did, it would eventually consume all the money and resources in the universe).
The idea of compounding applies to general life as well. Say Munger: “You don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.”
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Here's what you'll find in our full Poor Charlie's Almanack summary :
- A collection of Charlie Munger’s best advice given over 30 years
- Why you need to know what you’re good at and what you’re bad at to make decisions
- Descriptions of the 25 psychological biases that distort how you see the world
