Rich Man, Poor Man (The Power of Compounding)
by Richard Russell
by Richard Russell: The
The most popular piece I've published in 40 years of writing these
Letters was entitled, "Rich Man, Poor Man." I have had
dozens of requests to run this piece again or for permission to
reprint it for various business organizations.
entails a lot more than predicting which way the stock or bond markets
are heading or trying to figure which stock or fund will double
over the next few years. For the great majority of investors, making
money requires a plan, self-discipline and desire. I say, "for
the great majority of people" because if you're a Steven Spielberg
or a Bill Gates you don't have to know about the Dow or the markets
or about yields or price/earnings ratios. You're a phenomenon in
your own field, and you're going to make big money as a by-product
of your talent and ability. But this kind of genius is rare.
For the average
investor, you and me, we're not geniuses so we have to have a financial
plan. In view of this, I offer below a few items that we must
be aware of if we are serious about making money.
Compounding: One of the most important lessons for living in
the modern world is that to survive you've got to have money. But
to live (survive) happily, you must have love, health (mental
and physical), freedom, intellectual stimulation and money.
When I taught my kids about money, the first thing I taught them
was the use of the "money bible." What's the money bible?
Simple, it's a volume of the compounding interest tables.
is the royal road to riches. Compounding is the safe road, the sure
road, and fortunately, anybody can do it. To compound successfully
you need the following: perseverance in order to keep you firmly
on the savings path. You need intelligence in order to understand
what you are doing and why. And you need a knowledge of the mathematics
tables in order to comprehend the amazing rewards that will come
to you if you faithfully follow the compounding road. And, of course,
you need time, time to allow the power of compounding to work for
you. Remember, compounding only works through time.
But there are
two catches in the compounding process. The first is obvious
compounding may involve sacrifice (you can't spend it and still
save it). Second, compounding is boring b-o-r-i-n-g. Or I should
say it's boring until (after seven or eight years) the money starts
to pour in. Then, believe me, compounding becomes very interesting.
In fact, it becomes downright fascinating!
In order to
emphasize the power of compounding, I am including this extraordinary
study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306.
In this study we assume that investor (B) opens an IRA at age 19.
For seven consecutive periods he puts $2,000 in his IRA at an average
growth rate of 10% (7% interest plus growth). After seven years
this fellow makes NO MORE contributions he's finished.
A second investor
(A) makes no contributions until age 26 (this is the age when investor
B was finished with his contributions). Then A continues faithfully
to contribute $2,000 every year until he's 65 (at the same theoretical
Now study the
incredible results. B, who made his contributions earlier and who
made only seven contributions, ends up with MORE money than A, who
made 40 contributions but at a LATER TIME. The difference in the
two is that B had seven more early years of compounding
than A. Those seven early years were worth more than all of
A's 33 additional contributions.
This is a study
that I suggest you show to your kids. It's a study I've lived by,
and I can tell you, "It works." You can work your compounding
with muni-bonds, with a good money market fund, with T-bills or
say with five-year T-notes.
DON'T LOSE MONEY: This may sound naive, but believe me it isn't.
If you want to be wealthy, you must not lose money, or I should
say must not lose BIG money. Absurd rule, silly rule? Maybe, but
MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten
business deals, greed, poor timing. Yes, after almost five decades
of investing and talking to investors, I can tell you that most
people definitely DO lose money, lose big time in the stock market,
in options and futures, in real estate, in bad loans, in mindless
gambling, and in their own business.
RICH MAN, POOR MAN: In the investment world the wealthy investor
has one major advantage over the little guy, the stock market amateur
and the neophyte trader. The advantage that the wealthy investor
enjoys is that HE DOESN'T NEED THE MARKETS. I can't begin to tell
you what a difference that makes, both in one's mental attitude
and in the way one actually handles one's money.
investor doesn't need the markets, because he already has all the
income he needs. He has money coming in via bonds, T-bills, money
market funds, stocks and real estate. In other words, the wealthy
investor never feels pressured to "make money" in the
investor tends to be an expert on values. When bonds are cheap and
bond yields are irresistibly high, he buys bonds. When stocks are
on the bargain table and stock yields are attractive, he buys stocks.
When real estate is a great value, he buys real estate. When great
art or fine jewelry or gold is on the "give away" table,
he buys art or diamonds or gold. In other words, the wealthy investor
puts his money where the great values are.
And if no outstanding
values are available, the wealthy investors waits. He can afford
to wait. He has money coming in daily, weekly, monthly. The wealthy
investor knows what he is looking for, and he doesn't mind waiting
months or even years for his next investment (they call that patience).
But what about
the little guy? This fellow always feels pressured to "make
money." And in return he's always pressuring the market to
"do something" for him. But sadly, the market isn't interested.
When the little guy isn't buying stocks offering 1% or 2% yields,
he's off to Las Vegas or Atlantic City trying to beat the house
at roulette. Or he's spending 20 bucks a week on lottery tickets,
or he's "investing" in some crackpot scheme that his neighbor
told him about (in strictest confidence, of course).
the little guy is trying to force the market to do something for
him, he's a guaranteed loser. The little guy doesn't understand
values so he constantly overpays. He doesn't comprehend the power
of compounding, and he doesn't understand money. He's never heard
the adage, "He who understands interest earns it. He
who doesn't understand interest pays it." The little
guy is the typical American, and he's deeply in debt.
guy is in hock up to his ears. As a result, he's always sweating
sweating to make payments on his house, his refrigerator, his
car or his lawn mower. He's impatient, and he feels perpetually
put upon. He tells himself that he has to make money fast. And
he dreams of those "big, juicy mega-bucks." In the end,
the little guy wastes his money in the market, or he loses his money
gambling, or he dribbles it away on senseless schemes. In short,
this "money-nerd" spends his life dashing up the financial
the ironic part of it. If, from the beginning, the little guy had
adopted a strict policy of never spending more than he made, if
he had taken his extra savings and compounded it in intelligent,
income-producing securities, then in due time he'd have money coming
in daily, weekly, monthly, just like the rich man. The little guy
would have become a financial winner, instead of a pathetic loser.
VALUES: The only time the average investor should stray outside
the basic compounding system is when a given market offers outstanding
value. I judge an investment to be a great value when it offers
(a) safety; (b) an attractive return; and (c) a good chance of appreciating
in price. At all other times, the compounding route is safer and
probably a lot more profitable, at least in the long run.
with permission from Dow
© 2011 Dow