I went through advanced mathematics & collected an advanced degree in engineering without comprehending the enormity of compounding. Most people have no idea about the tremendous power of compounding to grow wealth. To be fair, unless we are exposed to this colossal power, our brain is simply not wired to comprehend what exponential growth is; it’s effect is, in a sense – fairly “non-intuitive”.
Consider the example below.
“I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer in this case is simply astounding. Double a penny a day for 30 days gets you, who knows, $10 million, $737,000 change” – investing legend Chuck Akre
Another related quote
“Compounding matters and does so far more than people expect. The human brain thinks in a linear way which means that if we were asked to estimate what 10.22% compounded over 100 years would be then our answer is likely to be closer to 1,022% than 1,679,600%, something economists call exponential growth bias. This means that compounding is often underestimated and should be at the heart of long-term investing” – Marathon Asset Management
Compounding is Back-loaded
Consider too, that compounding is heavily back-loaded.
Suppose you have found a way (a hypothetical fund, say) that compounds your 1 Lac in savings at 20% a year over a 30-year period. 1 Lac today would reach a value of 2.85 crores; what is important to note is that the last 5 year period (which is 5/30 = 16% of the duration of the investment) contributes 60% of the overall gain.
This runs counter to the general human tendency to demand immediate (front-loaded) gratification.We want to see large sums of money appear magically before our eyes – preferably very soon..
The more you elongate this time horizon, the more disproportionate the contribution of the last few years. Look at the chart once again to let the lesson of time sink in. More than 60% of the increase in value came in the last 5 years of a 30 year investing period.
Here’s a real-life example : 94% of Buffett’s wealth was created after he turned 60. As incomprehensible as this may sound, it is a direct implication of how compounding works.
Avoiding Losses
Losing money in any given year really hurts. Two consecutive years of loss really hurts a lot etc. This is why there is So much focus in value investing on not losing money, because it really upsets the rhythm of compounding and makes it very hard to ‘catch up’.
“Underlying our investment values is the principle that the mathematics of compounding demands putting a high priority on avoiding substantial permanent losses. That’s why we’re committed to owning high-quality businesses in industries we understand and can underwrite. It’s also why we put the emphasis we do on risk management.” Adam Weiss
The power of compounding is so great that our first job as investors is to avoid anything that might short circuit it” – Ira Rothberg
“Striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal. Many people think of us as a “value investor” and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor.” Chuck Akre
And finally, words of wisdom from investment legends Klarman & Munger :
“The effects of compounding even moderate returns over many years are compelling, if not downright mind boggling” Seth Klarman
“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things” Charlie Munger
Investment implications
- Because it is so hard for the human mind to grasp the power of compounding, it may be best to presume that we have a tendency to under-appreciate its potency.
- To reap the full benefits of compounding, avoiding losses is crucial (emphasis on minimizing down-side risk, staying away from leveraged business models, paying too much for a good thing etc..)
- Because compounding is heavily back-loaded, we will have to wait a while before seeing its effects.
- Allocating more, earlier pays off; One can’t suddenly earn more, but one can save more – and this gives the freedom to allocate more, early on.
- Deferred gratification is very powerful & can help families grow their wealth considerably. A belief in YOLO (you only live once) is also a way to justify short-termism and immediate gratification of wants (vs needs).
While this page aims to throw some light on the compounding of wealth, there are similar implications for us in regards to the compounding of knowledge & experience. Those who commit to learning, who are constantly renewing, and educating themselves are likely to see a disproportionately high degree of personal satisfaction that makes the process more rewarding than the destination.