Compounding

People tend to think about exponential growth in linear terms.

Imagine earning 10% interest on your $100 investment over 5 years

Each year, $100 x 10% = $10 return, right?
So in 5 years, you make
$10 x 5 years = $50 in returns
Then you should have $150 after your five year investment, right?

Not right.

In reality, you earn 10% interest on the total dollar amount you have in the investment each year. This includes 10% interest on the returns you gained from interest in previous years:

Year 1: $100 + ($100 x 10%) = $110
Year 2: $110 + ($110 x 10%) = $121
Year 3: $121 + ($121 x 10%) = $133
Year 4: $133 + ($133 x 10%) = $146
Year 5: $146 + ($146 x 10%) = $161 total investment

Such is the concept of compounding. Imagine the investment amount at 10 years (~$259), 20 years (~$673), 30 years (~$1745). The growth is exponential, not linear, within a 10-year time range. You can’t get accustomed to how quickly things can grow.

The first time people see a compound interest table or hear a story about how much more you’d have for retirement if you began saving in your 20s vs 30s, people are floored- it just doesn’t seem right.

Because compounding isn’t intuitive, we often ignore its potential and focus on solving problems through linear or iterative means. Physicist Albert Bartlett put it: “The greatest shortcoming of the human race is our inability to understand the exponential function.”

There are thousands of books about how Warren Buffett built his wealth and success. None of them are called “This Guy’s Been Investing For A Quarter Century”. But we know that’s the key to the majority of his wealth- it’s just so obvious it’s hard to accept.

It is so easy to overlook how powerful it can be to take something small and hammer away at it, year after year, without stopping. Because it’s easy to overlook, we miss the key to making anything big. How can most of Buffett’s success be attributed to what he did as a kid? Since it’s crazy and counterintuitive, we overlook the most crucial lesson about investing:

Shut up and wait.

The counter-intuitiveness of compounding is responsible for the majority of disappointing investment strategies when forgotten. Good investing isn’t necessarily about earning the highest returns because those returns don’t happen consistently enough. It’s about earning pretty good returns that you can stick to for a long time. The difference gained in your investment compounds over time. That’s when compounding runs wild. That’s when you look back in wonder. But because compounding looks amazing only in hindsight, and therefore often missed in foresight.

Charlie Munger explains, “The first rule of compounding: Never interrupt it unnecessarily.” Wealth is money that grows. Growing money can only grow when it sits in your investments, untouched. Wealth is money others don’t see. The social utility of money runs counter to the growth of wealth.

Often times, you have to relentlessly leave alone something that looks small to give it the chance to compound into something big.

Build a repertoire through small, consistent acts. That’s where everything huge begins.

Leave a Comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s