[Editor's note: CNBC's "Your Money, Your Future" is intended to help Americans take control of their finances. In this case, we've gone into the past—both recent and distant—to provide critical investing advice for your future.
One of the most important—and least intuitive—concepts for financial literacy is the power of compounding. Most people don't understand what Ben Franklin did: that time is an investor's most important ally. CNBC asked John Bogle, founder of The Vanguard Group, to contribute his thoughts about compounding, a subject he has returned to many times over the years in his books and other writing. He contributed this piece for CNBC, adapted from a speech he gave a few years ago to the Greater Philadelphia Venture Group.]
The civic virtue that Benjamin Franklin brought to his entrepreneurship and invention has overshadowed the remarkable wisdom of this investment sage. Perhaps because it is so simple that it seems unremarkable, this wisdom goes virtually unheralded among his other grand accomplishments. With his simple precepts, he would have realized that in this new age of investing, we have ignored the crucial lesson: Simplicity trumps complexity. All of that shuffling of paper shares of stock that we read about in the press—in the United States, nearly 4 billion shares of stock are traded each day, some 1 trillion shares a year—is engaged in by speculators attempting to garner competitive advantage, even as it inevitably slashes the returns earned by investors as a community.
While investing in stocks and bonds as we know it today hardly existed in Franklin's era, his sensible advice about savings sets a high standard for today's investment books, most of which provide complex programs that promise to "beat the market" yet inevitably fail to deliver on that promise. In my own books, however, I did my best to focus on the simple principles that define investment success. These investment ideas, it turns out, are eerily similar to Franklin's ideas about savings, set forth largely in his classic, "The Way to Wealth," first published in 1757. A comparison of the two philosophies suggests that wisdom about sound financial principles goes back at least as far as Franklin's homespun formulations about savings, echoed in Vanguard's founding investment precepts.
Perhaps the best place to begin is with Franklin's acute understanding of the miracle of compound interest. According to Philadelphia Inquirer journalist Clark DeLeon, "In 1785, a French mathematician wrote a parody of Franklin's Poor Richard called Fortunate Richard, in which he mocked the (to him) unbearable spirit of American optimism represented by Franklin. The Frenchman wrote a piece about Fortunate Richard leaving a small sum of money in his will to be used only after it had collected interest for 500 years."
"Franklin," DeLeon continued, "wrote back to the Frenchman, thanking him for a great idea and telling him that he had decided to leave a bequest to his native Boston and his adopted Philadelphia of 1,000 pounds to each on the condition that it be placed in a fund that would gather interest over a period of 200 years." Franklin assumed that the funds would accrue interest at the annual rate of 5 percent, bringing each original 1,000 pounds to 131,000 pounds ($232,000 at today's exchange rate) after 100 years, and 17,300,000 pounds ($31,000,000) in 200 years.
For a variety of practical financial reasons and complex legal reasons, when Franklin's trusts expired 200 years later, in 1994, those totals were not nearly reached. (Boston's funds were worth almost $5 million and Philadelphia's about $2.25 million.) Nonetheless, the results were an impressive display of the massive accumulation of capital that could be achieved when the explosive mix of rate of return and time are combined. We call that mix "the magic of compounding."
Similarly, for as long as I can remember, compound interest has been at the center of my own investment thinking. The opening words in the very first chapter of my very first book (Bogle on Mutual Funds, Irwin Professional Publishing, 1993. In the book, I used a $1 initial investment rather than the $1,000 in this example.) were: "The Magic of Compounding. 'The greatest mathematical discovery of all time' is how Albert Einstein described compound interest ... the value of $1,000 invested in stocks in 1872 would have grown to $27,710,000 in 1992 [when the book was published and the historical rate of return on stocks was 8.8 percent.] ... the magic of compounding writ large."
While that 8.8 percent rate of return was higher and that 120-year period shorter than Franklin's 200-year horizon, both periods seem so long as to be useless in our own personal financial planning. Since a comfortable retirement is the principal objective of nearly all U.S. families, in my book, "The Battle for the Soul of Capitalism," I use a 65-year time horizon, one that assumes a 45-year working career (to age 65) and a further 20 years of life (to age 85) based on today's actuarial tables: "$1000 invested at the outset of the period, earning an assumed annual return of, say, 8 percent would have a final value of $148,780—the magic of compounding returns."
But I quickly warned that this total was unlikely to be achieved. Why? Because the obvious magic-of-compounding returns was all too likely to be overwhelmed by the subtle tyranny of compounding costs—a concept that, in a simpler age, even the great Franklin failed to contemplate. Here's what happens:
"Assuming an annual intermediation cost (by mutual fund managers) of only 2.5 percent, the 8 percent return would be reduced to 5.5 percent. At that rate, the same initial $1000 would have a final value of only $32,465—the tyranny of compounding costs. The triumph of tyranny over magic, then, is reflected in a stunning reduction of almost 80 percent in accumulated wealth for the investor ... consumed ... by our financial system."
When our financial system—essentially our money managers, marketers of investment products and stockbrokers—put up zero percent of the capital and assume zero percent of the risk yet receive fully 80 percent of the return, something has gone terribly wrong in our financial system. As I note in the book, "the shift in our system from owners' capitalism to managers' capitalism has been devastating to investors."
The principles of sensible savings and investing are time-tested, perhaps even eternal. The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today's financial service system and rely on the magic of compounding returns. While the interests of the business are served by the aphorism "Don't just stand there. Do something!" the interests of investors are served by an approach that is its diametrical opposite: "Don't do something. Just stand there!"
—By Jack Bogle, founder of The Vanguard Group