Bitcoin offered the promise of riches. But after the last two years, I suspect most coin owners are more familiar with the sinking feeling that comes as the price slides lower (Bitcoin is down by nearly 50% since July).
A few lucky people bought Bitcoin when it was cheap and were disciplined or lucky enough to sell at the top. But sadly, history suggests that most people who make big profits in a speculative boom fail to hold on to them.
I think the real secret of how to become rich lies elsewhere. In this article I want to share this secret with you and explain how I’m using the same technique to build my retirement savings. I reckon it should work for you too.
A simple truth
All the rich people I’ve ever known have one thing in common. Even though they’ve come from different backgrounds and made money in different ways, this one truth ties them together.
To be clear, I’m not talking about people with high incomes who spend all their cash on a lavish lifestyle. By rich, I mean people who are financially secure — who can live comfortably without needing to work for a living.
What do these people have in common? In my experience, they all understand the power of compounding.
How does compounding work?
Compounding means earning interest on previous years’ interest.
For a business owner, it means reinvesting last year’s profits back into the business, rather than spending the money on holidays or a flash car. By doing this, businesses can expand more quickly, hire better staff and develop new services. The end result is that the earning power of the business grows much more quickly than it would have done otherwise.
For stock market investors, compounding means using last year’s dividends and any trading profits to buy more shares. Never withdrawing a penny.
Earn 75% extra
Let’s look at a simple example. Imagine a stock that delivers average annual returns of about 8%. Each year, the share price rise by 3.5%, while the remaining 4.5% return is paid out as a dividend. This is similar to the historical average returns from the UK stock market.
Let’s imagine you invested £10,000 in this stock 10 years ago.
If you’d withdrawn the dividend each year and relied on share price growth, then your investment would be worth £14,106 today — an increase of 41%.
On the other hand, if you’d used the dividend cash to buy more shares each year, then your investment would be worth £21,589 today — an increase of 116%.
As a result of compounding your dividend income, you’d have earned 75% extra in 10 years.
That’s the power of compounding. If you reinvest your income, you turbocharge your profits.
A short cut to wealth
Rich people understand that compounding provides a short cut to wealth.
The good news is that you don’t need to be a business owner or a stock market wizard to get rich with compounding. A FTSE 100 index tracker fund or a basket of dividend-paying stocks should work very well.
The secret to successful compounding is to keep paying in and never to withdraw anything until you have enough to retire.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.