“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
I started to use the concept of “compounding” only about 12 years ago. I was well aware of the word and its meaning by then but did not use it other than in the context of “compound and simple” interest calculations in mathematics problems. In hindsight, the use of the word twelve years ago turned out to be an inflection point in my personal growth journey — mostly on the financial side though. However, the perspective I developed in the last year with regard to the concept of compounding has been a lot more fundamental and a lot more pervasive. No wonder I feel very excited writing this piece. I wish that you find this piece stimulating and meaningful.
The real difference has been internalizing “compounding” — in other words, developing a “compounding” mindset.
At the most basic level, compounding entails growth from a baseline, resetting the baseline to the original plus growth, then growing from this larger baseline, and then repeating this process again and again and again. The power of compounding comes not so much from the amount (%) of growth but from the number of times you repeat the growth iterations. One of the relatively well-known implications of the power of compounding is that small improvements repeated a number of times can create significantly more overall value than large improvements repeated fewer times. This implication is powerful because small improvements are easy to achieve any number of times than large improvements even if for fewer times. This is a direct consequence of the formula of compounding (initial baseline X ((1 + growth rate) ^ (number of iterations)).
I was able to (kinda) appreciate this and implement this for twelve years (12 is not a large number of iterations, I know). The transition to compounding mindset is relatively recent though. Now I evaluate everything I do in terms of whether it is a compounding activity or an expending activity — (just to be sure, I’m not suggesting that expending is a vice). There are certain activities in life that benefit from compounding and there are certain activities that perhaps atrophy with time and use.
Examples of things that benefit from compounding:
- Knowledge: Acquisition of knowledge tends to compound with time and activity. As you make headway into an area of your interest by acquiring knowledge in that area, you tend to build on that knowledge by being able to progressively learn more and more involved concepts in that area, thereby progressively expanding knowledge
- Fitness: Your ability to accomplish bigger and harder targets tend to compound with effort and time. For example, one initially tends to struggle to run even for short distances. But with consistent effort over a period of time, one is able to run longer distances with relative ease and run faster too
- Health: Interest in eating healthy food and ability to sleep well also tend to compound. Initially, both of these are difficult but over time, one can get a strong handle on both
- Relationships: Genuine interest and time spent in relationships with people who matter in our lives — this clearly lends itself to compounding
- Career/vocation: Constantly changing jobs for better pay or designations is not exactly taking the path of compounding. One can however build on qualities such as deepening network or specific professional capabilities with carefully planned changes in role or job thereby compounding in the path
Examples of collecting/aggregating/expending activities:
- Watching movies, web-series and such: No doubt, catching a nice movie can be relaxing, refreshing and rejuvenating but this feeling does not compound with watching more movies — it may in fact most likely result in a reduction of marginal satisfaction
- Eating Out: Eating out can be fun and relaxing but this lasts typically for only so long as one is actually engaged in the activity. Done too frequently, satisfaction levels tend to come down
- Transactional social relationships: While relationships with close family and friends can compound with time, transactional social relationships that hang on pure social or professional conveniences do not tend to compound — many times, they fall apart or disappear rather quickly and easily
How do build a compounding mindset
- by developing good, sustainable habits
- by making good habits automatic — not involving the need for motivation and inspiration
- by focusing on process/systems over outcomes; by focusing on controllables and not fixating on non-controllables
- balanced life is more amenable for compounding activities
What inhibits compounding
- avoiding challenges
- tendency to engage in random activities
- busy and fully occupied lives
- Interesting work has compounding properties whereas commuting to work typically does not
- Traveling can be compounding but touristy vacations may not
- Results of compounding are slow to manifest in the beginning but pick up super speed at later stages
- In compounding activities, one typically tends to have some energy left in reserve whereas, in non-compounding activities, energy reserves are generally used up all the time
- Compounding is more like fat and protein in the body whereas non-compounding activities are more like glycogen (carbohydrates). It follows that one needs to engage in a judicious mixture of compounding and non-compounding activities for maximum impact
- Compounding activities tend to be long-term oriented and typically involve deep work whereas non-compounding activities tend to be day-to-day and involve shallow work
- The most obvious statement of the century: compounding is non-linear (well, by definition!)
- Hence, compounding is non-intuitive and hence very difficult to internalize