"Compound interest is like being at the top of a very large hill with wet snow and starting with a snowball and getting it rolling downhill," Warren Buffett (Trades, Portfolio) once said at a Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholder meeting. He attributed the metaphor to Charlie Munger (Trades, Portfolio), but it aptly describes the power of compounding returns – a fundamental principle that has guided his investment strategy from the beginning.
The snowball effect: Discover the power of compounding
The analogy of a snowball rolling down a hill neatly captures how compound interest works. As the snowball rolls downhill, it continuously picks up more snow. The bigger it gets, the more snow it accumulates with each turn. Before long, it has morphed into a gigantic boulder.
Investing works much the same way. Even small initial investments can grow exponentially over time as the returns compound. Each year, investment gains are earned not only on the initial capital, but also on the accumulated gains from previous years. The earnings begin to build on themselves.
For example, $10,000 invested at a 7% annual return would be worth over $19,000 after 10 years. The following year, the 7% return would be earned on $19,000 rather than the original $10,000. As the investment snowballs in size, each year's returns compound on top of previous gains, accelerating the growth.
This compounding effect allows investments to grow faster and faster as they build on previous gains year after year. While it takes time, compounding creates an unstoppable momentum, just like a snowball whizzing down a hill.
Long-term investing: The key to the snowball effect
The power of compounding only manifests itself over long time horizons. The longer an investment can compound returns, the more powerful the snowball effect becomes.
This is why taking a long-term perspective is critical if investors want to harness the magic of compounding interest. The snowball effect does not work over weeks or months. It takes years or even decades for the snowball to really gain momentum.
Consider the example of Coca-Cola Co. (KO, Financial). Its shares have returned 10.4% annually in the last 30 years through consistent dividends and capital appreciation. If you had invested $10,000 in Coca-Cola in 1991, it would be worth $237,143 today thanks to the power of long-term compounding.
Dividend reinvestment: Accelerating the snowball
One of the best ways to accelerate the snowball effect is by reinvesting all dividends and capital gains.
Rather than spending this investment income, investors can opt to automatically reinvest it to buy more shares. This keeps recycling gains back into the portfolio to compound future growth.
Companies like Coca-Cola pay steady and rising dividends over time. Reinvesting these growing dividends to buy more shares creates a powerful compounding effect. Each new share adds more dividend income to reinvest.
Consistent investment: Building the snowball
In addition to reinvesting all gains, investors can fuel the snowball effect by making regular, consistent contributions over time.
Even if the amounts are small, making routine investments early and frequently gives compounding more capital to work with. It is like packing more snow onto the snowball with each turn.
Consistent investing builds wealth slowly but surely. Investors just need discipline to keep plowing money into the snowball, even during market downturns.
The snowball effect in practice
Johnson & Johnson (JNJ, Financial) is another classic example of the snowball effect in action. The company has increased its dividend for 60 consecutive years.
Someone who invested $10,000 in Johnson & Johnson in 1991 and reinvested all dividends would now have over $420,000 thanks to the magic of long-term compounding. Hang on to that investment for another 10 years, and it will snowball into over $1.3 million.
This example shows how ordinary investors can harness the snowball effect themselves simply by starting early, staying invested and letting their money work for them over time.
How Buffett harnessed the snowball effect
Few investors have utilized the snowball effect as effectively as Buffett. He recognized the power of compounding early on and made it work for him in several ways:
- He started young: Buffett bought his first shares in his teens, giving compounding more time to work.
- He reinvested the profits: Rather than spend gains, he plowed them into more investments.
- He focused on quality: Buffett targeted companies with durable advantages that prospered over time.
- He held investments, allowing winners to compound over decades.
- He lived frugally: Buffett funneled his savings into investments.
The results speak for themselves. Had someone invested just $10,000 into Buffett's partnerships in 1957, it would be worth an astonishing $350 million today.
While he was patient, the guru was also opportunistic, deploying more capital when prices were favorable. This gave the snowball added pushes downhill whenever valuations were attractive.
So if you were to follow in Buffet’s footsteps, instead of leaving your investment in Coca-Cola at the initial $10,000 and reinvesting only the gains, you would expand the investment. Let’s say you invested an additional $100 every month. By now, your investment would have grown to $499,231, which is nothing to sneeze at.
Practical tips to leverage the snowball effect like Buffett
So how can investors leverage the snowball effect to grow their wealth like Buffett? Here are some practical tips to help you:
- Start investing early: Give compounding more time to work its magic by investing at a young age like Buffett did. The earlier you start, the more powerful the snowball effect.
- Reinvest all gains: Don't spend investment income. Reinvest dividends, interest, profits from sales and other gains to buy more shares and compound returns.
- Make consistent contributions: Fuel the snowball effect by investing regularly over time, even in small amounts. This gives compounding more capital to work with.
- Buy quality investments: Focus on companies with durable competitive advantages that can prosper over decades. These tend to compound returns.
- Take a long-term view: Think in terms of years and decades, not weeks or months. Compounding takes time to work.
- Remain patient: Have discipline to stay invested through ups and downs. Do not panic sell during dips or downturns.
- Increase contributions: As income rises, invest more to give the snowball added pushes downhill.
- Add on dips: Use market declines to increase positions in quality investments at better valuations.
Heave that snowball downhill now to grow your wealth
The immense power of long-term compounding allowed Buffett to turn small, consistent investments into vast wealth. Like a snowball turned boulder, reinvesting gains into quality companies decade after decade compounded his money from thousands to billions.
Follow Buffett’s lead: Start investing now in excellent companies reinvest all dividends and earnings, have patience through volatility and let time work its magic. Harness the snowball effect by compounding returns over your lifetime.
Before you know it, the positive effects of compounding will gain momentum, just like a snowball whizzing downhill. Implement Buffett’s buy-and-hold strategy focused on quality, reinvestment and longevity to grow your wealth exponentially thanks to the power of compound interest. It is time to put the snowball effect to work for you.
