It's possible to turn a small amount of money into much more money through the power of compounding interest. To illustrate this, let's look at the story of an imaginary small business owner.
Imagine that in 1950, a family in the United States—let's call them the Smiths—bought a Dairy Queen franchise. They set up a tiny business called Smith Family Holdings to operate this franchise. Their small company provides a comfortable living.
Through years of hard work, their business becomes ingrained within the fabric of the community. There never seems to be a lot of money left over, but it does put food on the table and provide employment, making it worth the trouble despite the headaches of employees, insurance, and capital expenditures that are an inevitable part of owning a small business.
- Compounding, or reinvesting profits earned over time, offers the potential for much more growth than when profits are spent elsewhere.
- The power of compounding can be applied to many investments, including stocks, bonds, real estate, and small businesses.
- In addition to reinvesting profits, investors also benefit from regularly contributing to investment portfolios.
A Small Investment Grows Quietly
Mr. and Mrs. Smith decide they want to invest in their family's future, but they don't know much about finance or the stock market. Following the advice of some of history's great investors, they look at a market they understand. They began to poke around their business and research the companies that provided them with the products they resell to their customers.
The Smiths realize that, in the ice cream industry, most of the candy toppings are produced either directly or indirectly by two firms: Mars Candy and The Hershey Company. Snickers, Reese's Peanut Butter Cups, M&M's, Butterfingers, Baby Ruth, and a whole host of related toppings provide the perfect flavor for their customers. These products also sell well in local supermarkets, movie theaters, and gas stations. Mr. Smith figures that if someone loves Snickers bars, they aren't going to suddenly stop eating them because they are an affordable luxury.
Unfortunately, Mr. Smith discovers that Mars has always been, and remains, a privately owned family business so he can't invest in it. The Hershey Company, however, is very much public. The Smith family decides to set aside $10 per week, which is all they can afford.
They create a small family retirement program and enroll in Hershey's direct stock purchase plan, which allows them to buy shares for little or no commission directly from the company. The family also always reinvests their dividends.
Virtually all major public corporations have direct-buy programs for their stock, though most new investors don't know about them because brokers want to get the commission on trades.
The Smith family goes about its business and, upon the death of Mr. and Mrs. Smith, the family business gets passed on to their two children, Susie and Walter, who continue to run it. Without fail, Susie continues writing the weekly $10 check for Hershey's stock that her mother had faithfully written over the years. They never increased the amount saved each week, meaning that the $10 now represents less than the cost of a single movie ticket.
Since it was part of a retirement plan owned by the company, neither Susie nor Walter Smith paid much attention to the Hershey stock account their parents had originally set up all those years ago. They figured that $10 a week was small, so they hoped that any extra money left over when they retired and sold the Dairy Queen would be a nice bonus to provide a little extra security.
The Power of Compounding
One day, Susie and Walter, now middle-aged with kids of their own, decide they can't run the restaurant anymore. The capital expenditures continue to increase, they don't want to commit to a new business loan, and they feel that it is time to move on and start anew. They meet with the accounting firm that worked with their parents for decades and begin the liquidation process.
After paying off their bills and debts, the two are left with a bit of money—$50,000, mostly representing equity in the business's real estate. Other than the jobs the franchise provided the family members, there isn't a lot to show for years of effort and hard work. With a mix of sadness and relief, this chapter of the Smith family has come to a close. Walter and Susie figure they will split the $50,000 and be done with the restaurant business forever.
They meet with the accounting firm, take their $25,000 checks, and get up to leave. As they stand to walk out of the office, the accountant looks confused. "Where are you going? We still haven't discussed the retirement plan!" he says. Thinking of the tiny weekly contributions, Susie responds, "Just sell everything, liquidate it, and send us a check for whatever is in there. It can't be much."
The accountant pulls out a statement and hands it to her. As Susie looks down at the page, she does a double-take. The Smith Family Holdings retirement program, which never received more than $10 a week in contributions, now contains 226,040 shares of Hershey Foods stock. At $47.20 per share, the value of the family's holdings is $10,669,088. Hershey's pays an annual dividend of $1.28 per share, so the account is earning $289,331.20 pre-tax each year, or $24,110.93 per month, which is being plowed back into the plan to buy even more shares of Hershey's.
Compound interest can vastly increase an investment's value, as interest continually applies to not only the original principal, but the interest already earned and the dividends reinvested.
Walter and Susie are shocked that they knew nothing about this incredible sum of money. "Well, due to the fact the investments are held by your company, Smith Family Holdings, and it is a retirement plan, none of this income or wealth ever showed up on your tax returns," their accountant explains. "Your parents didn't want to liquidate the account because they would owe taxes on the withdrawals. They figured the longer the money was left undisturbed to grow, the better for the family."
Create Your Own Wealth
Given enough time, small amounts can become great fortunes due to the power of compound interest. Stocks, bonds, mutual funds, real estate, options, original artwork, car washes—any of these can be vehicles that allow you to grow your money.
Any small business owner who has even a few dollars left over at the end of the week is holding the power to become wealthy in their hands. It just comes down to the rate of return they can earn or the length of time they can let the money grow undisturbed. It isn't rocket science; it's simple math. A little bit of money can always be turned into more.
An Even Better Plan
Mr. and Mrs. Smith could have even grown their family fortune more by investing in multiple companies that they understood—Hershey's, PepsiCo, The Coca-Cola Company, Tootsie Roll Industries, and The H.J. Heinz Company, just to name a few. Imagine if the Smith family all had outside jobs and worked in the restaurant for free. They could have taken their salary and written a "paycheck" to their direct stock purchase plans. In that case, the family would have been worth more than $100 million.
In today's economy, it's possible to turn a little bit of money into a great fortune with some hard work and planning. If you make an investment plan and treat those stock payments as bills that must be paid every week or month, you can steadily watch your wealth grow with every $10 or $20 you invest.