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Albert Einstein once called compound interest the eighth wonder of the world. He said: “He who understands it, earns it… he who doesn’t, pays it.”
This is well-covered territory among us investors. We understand that compound interest is powerful because interest earns interest, and over time (with extra emphasis on time), that snowballs into something far larger than most people can wrap their heads around.
Having said that, I think the most wonderful part about compounding — and the part that doesn’t get talked about nearly enough — is how forgiving it can be. And in a game where mistakes and occasionally losing money are inevitable, that’s an incredible perk to have.
In other words, compound interest benefits you much more to the upside than it hurts you on the downside. I was reminded of this recently while listening to an episode of the Excess Return Podcast, where Gautam Baid, author of The Joys of Compounding, introduced an idea we’ll call the asymmetric power of compounding.
Let’s walk through a simple example.
Imagine you invest $100 in Stock A and $100 in Stock B, for a total portfolio value of $200. In year one, Stock A goes up 25%, while Stock B goes down 25%.
After year one, you’re break-even. Stock A grows to $125, while Stock B falls to $75, leaving you with the same $200 you started with. Pretty straightforward.
Where this gets interesting is when this same pattern plays out over a longer period of time. Extending this example out over a full decade, let’s assume Stock A compounds at +25% every year for ten years, while Stock B declines by –25% every year over the same period.
After ten years, here’s where you end up:
Stock A grows from $100 to about $931
Stock B shrinks from $100 to about $5.63
Your total portfolio ends the decade worth nearly $937 — almost a 5× return — despite one half of it being a complete disaster. That works out to a compound annual growth rate of roughly 16.7% for the entire portfolio.
In this example, even though one stock essentially went to zero, the portfolio still grew at a pretty incredible rate because of the forgiving, asymmetric power of compounding.
Now, there are a lot of lessons you could take from this, but in a game where mistakes are unavoidable, one stands out to me in particular: it’s actually okay to make mistakes.
You don’t need to get everything right to build wealth through investing. If you have time on your side and give it room to work its magic, a few good decisions can help you far more than a few bad ones can hurt you.
With that said, now I want to hear from you: What’s been the biggest compounder in your portfolio? Let me know in the comments below!
