The Magic of Compounding at Age 50

 | Mar 07, 2014 | 11:00 AM EST
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One of our illustrious contributors here at RealMoney celebrated a milestone birthday this week, turning over the "odometer" and replacing the "4-handle" with a "5-handle" on his age.

I will not name names, but occasionally in life and the markets, it is good to look back a bit in order to gain perspective. Among many things, the perspective of time can inform your investment decisions in a way that few other experiences can.

Consider the most important element of investing, the magic of compounding. Passionate investors learn about it early in their careers and certainly accept the mathematics of it. Most people need the wisdom of years to truly believe that it can actually happen. In 1964 -- the reference year for our exercise today -- who could believe that former technology leader IBM (IBM) could compound at 9% annually and today be worth $195 billion? Who then would have believed that the Dow Jones Industrials could compound at 6.2% annually, growing from 804 then to 16,360 today?

Those numbers may seem reasonable in retrospect, but do you really believe in compounding now? If the Dow compounds at half that rate for the next 50 years, our grandchildren will be watching Squawk Box discussing Dow 75,000. If it compounds at the same historical 6.2% rate, Squawk will be discussing Dow 333,000. Do you really, truly believe those numbers? For our young readers in their 20s, can you fathom seeing the Dow over 300,000 in your lifetime?

 If our $17 trillion economy compounds at a leisurely 2% real rate for the next 50 years, our grandchildren will enjoy annual production of $46 trillion. Even more exciting, what if the most important demographic shift of our time continues -- that of falling birth rates? Our per capita GDP today is $54,100. If population stays flat for 50 years, our grandchildren will enjoy a per capita GDP of $146,000.

Think about that for a moment. For a two-income household, that puts average household income at $292,000. Today, $394, 000 places your household in the top 1%. The "1 percenters" may be in rarified company today, but our grandchildren will all be close to 1 percenters by today's standards (on average, of course).

Perhaps a flat population cannot realistically grow GDP at 2% -- it will require plenty of productivity improvement via more automation -- but we can guess that they are quite likely to have more material income than we do today.

Before I wax too enthusiastic, we need to ponder the dark side of compounding as well. Since the creation of the Federal Reserve in 1913, the U.S. dollar has lost 96% of its value, according to many estimates. This is a compound annual decline of over -6%. Take a look mid-stream at some of the prices of daily necessities from 1964:

Using simply the consumer price index, the value of the dollar has declined 87% since 1964; in other words, absent other factors those goods should be priced around the amounts listed in this table. Some of the deviations give hints about our story of economic changes over the past 50 years.

Before we let our grandchildren gloat about the riches they can expect someday, let's remind them where the cost of living is going. If the Federal Reserve continues to shrink the value of the dollar at the 2% rate that seems to be their inflation target, check out the cost of living that will confront Generation Z:

 For those of us that do not fully trust the CPI, we can use gold as a proxy for the value of the dollar -- as gold is supposed to be the only real currency that cannot be debased. Gold was pegged in 1964 at $35.10 an ounce and since then has compounded at 7.6% annually to the current price of $1,335. If the Fed's 2% inflation target is realized, 50 years hence it should trade near $3,600. If it compounds at a rate similar to the last 50 years, it will trade at $50,800!

At the targeted inflation rate, a dollar in equities -- in other words, in real, growing, goods-producing businesses -- is likely to yield far more wealth than gold. If inflation rages, gold will do well. But I suspect dynamic businesses will adjust their prices accordingly, and still outperform the inert metal.

I am a fan of gold as an alternate currency and substitute for cash. Gold makes sense for your "hedge" allocation. However, if you can wrap your mind around all these numbers we have examined, and believe our country has the system, energy, work ethic and ingenuity to pursue growth, how can you not make a long-term commitment to equities in order to build wealth?

I am sure RealMoney's newly-old contributor intends to compound his "years lived" at a satisfactory rate for decades to come. If I were him, and I am not saying I am, I would also use this wonderful forum for the shout outs that truly matter in life -- the real wealth beyond money.

He would thank his parents for bringing him into the world 50 years ago, raising him with love and high expectations, and giving him all the advantages a parent can bestow. He would thank his wonderful wife who has faithfully accompanied him for the majority of the journey so far, and is looking forward to many more adventures together. And he would thank his two beautiful girls for bringing to his life the joy that only a parent can truly understand.  

Yes, that is definitely what I would do if I turned 50 this week.

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