The most powerful law in the world?

We are studying information failure this week and at one point during the lesson today I was tempted to spurt out that the biggest information failure of all was the failure of people to understand the law of compound interest. That was going to be in the context of discussing why people often leave it so late to start saving money when a small pot earning interest on a compound basis over a large time period can grow very quickly if it invested for long enough. Just small changes in the annual return - say from 2.5% pa to 3.0% pa can have an enormous effect on the final value of a pension fund. MindYourFinances has a good example to use by way of illustration.

I will leave that discussion until the next lesson ... but tonight I picked up a piece by John Kay which will appear in the FT tomorrow on the wealth of Warren Buffett newly crowned as the world’s richest man. Kay reinforces the power of compound interest in shaping the value of the Buffett Foundation.

“Albert Einstein supposedly observed that the most powerful force in the universe is compound interest, and Mr Buffett’s frugality has enabled compound interest to work its magic. During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world.”

Read the rest of John’s piece here