159. but Compounding does not really work!
“Many of life’s failures are people who did not realise how close they were to success when they gave up.” — Thomas Edison
I put together four graphs in the picture above. The first three track the stock prices of Apple, MRF Tyres and Bajaj Finance respectively from the beginning of 2003 until now (April, 2024). I picked these three rather randomly among hundreds (or thousands?) of stocks that may have performed very well over this period. The fourth graph tracks a theoretical quantity, compounded monthly with growth rate in the same ballpark as the performance of Apple, MRF and Bajaj Finance stocks for this 21-year period.
If you were to smooth the graphs out, the three stocks seemed to have compounded well with differing growth rates of 37%, 27% and 42% respectively somewhat like the fourth graph which tracks theoretical compounding at yearly growth rate of 29% (compounding monthly). If you ignore noise in the data, stock graphs tracked, more or less, the classic compounding path, i.e., the fourth graph.
“A map is not the territory it represents, but, if correct, it has a similar structure to the territory, which accounts for its usefulness.” — Alfred Korzybski
But can we ignore noise in these three graphs? The noise represents the short-term fluctuations in stock prices. They are akin to what our daily lives are about. The humdrum of daily life is full of dynamism — with traffic delays, sick days, with bosses being angry but also fun meetings with friends and family, ice cream days etc. And yes, stock prices also go up and down daily — almost always for no apparent rhyme and reason. Only when you abstract yourself out of this daily din will you start seeing any patterns.
Two such indubitable patterns are simple and compounding curves. Fortunately, many things in our lives compound. People move up from poverty into lower middle class, then to middle class and further to upper middle class. This may happen over generations but the fact is that humans do have tremendous ability to improve their lot. Most careers follow, largely, simple growth curve with perhaps a small component of compounding thrown in. Even evolution of species follows compounding path.
In many ways, we can make compounding growth inevitable with consistent efforts of the right kind. So, why does it feel like a struggle to capitalize on this in achieving success in careers, wealth, health, relationships etc? This is because “compounding” is an exquisitely smoothened-out model of reality. However, reality is anything but smooth. It is messy and haphazard. Growth happens in spurts with occasionally progressive but mostly regressive movements. In the daily rigmarole of chaotic events and emotions, we do not see life unfolding along a nice, smooth compounding curve. This makes it difficult to maintain belief and motivation that consistent right efforts will eventually yield results that are akin to theoretical compounding growth.
“Fall seven times and stand up eight.” — Japanese Proverb
Compounding requires growth mindset. Growth requires learning. Learning requires failures. Failures necessarily mean setbacks. We are told to learn from mistakes but many times, we struggle to get objective enough to be able to learn from failures and even then, sometimes, we take a long time to learn. Failures are not a guarantee for eventual success but are most likely a necessary precondition for success.
Only when the right efforts face the right circumstances does progress materialize. Sometimes, even when you do all the right things, things may not work for you because your circumstances may not be right. Also, even an individual human life is a complex adaptive system. If you focus solely on extraordinary financial wealth or career growth, you may end up compromising on other important aspects of your life such as your health or relationships. Setbacks in health or relationships will, in turn, eventually hit your efforts to achieve extraordinary careers or wealth.
“Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.” — Seth Klarman
Human beings are decidedly emotional. Our emotions are triggered by a wide diversity of factors: stimuli from the world, nutritional balance within the bodies, the quantity and quality of sleep etc. Many of these factors are not in our control. Our emotions sometimes buoy our efforts towards progress and sometimes hinder us from taking the right steps. So, our progress curve is hardly ever smooth. It typically feels like every forward step is accompanied by a number of backward steps. It is hard to stick to compounding path because the real benefits of compounding accrue towards the end but its hard to persevere through setbacks until then.
Bottomline
“Understanding both the power of compound return and the difficulty getting it is the heart and soul of understanding a lot of things.” — Charlie Munger
Compounding is real, is possible and is prevalent. The reason why we struggle with achieving compounding growth is that we do not see it in real time. It is only in hindsight that we ever see any compounding effect. Compounding in real life is messy, occasionally exhilarating but mostly depressing. Compounding effect takes a long time to manifest and all that while testing every aspect of your resolve and stretching every iota of your resilience. It is no wonder that most people struggle to persevere through the ordeals along the path of compounding. This realization alone has potential to break you free from these struggles.
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