I came into the living room and saw the glass panel lying on the carpet. It had fallen from the TV cabinet I had custom-made for me a few years ago. Seems the double-sided tape holding it to the front of an equipment drawer had given way. I brought the matter up with Mike, who had built the cabinet. He sagely opined, “Gravity is a patient foe.”
The solution Mike had devised was adequate to resist gravity for a while. But over the course of years the adhesion of the glue to the glass had weakened. Gravity took a long time, but its inexorable force ultimately won the day.
Compound interest is like that. When I look at my bank statement the smallest number is invariably the deposit of interest earned. Yet there’s an urban myth that Albert Einstein called it the most powerful force in the universe. He probably didn’t opine on compound interest, but every urban myth rests on a foundation of plausibility. That is because compound interest is like gravity in its inexorable effect over time.
It looks small on a single financial statement, but over the course of years it adds up.
This force operates against you when you are in debt or for you when you are saving.
Most things you encounter day-to-day are described by linear equations. When your wage rate changes your take-home pay changes linearly. But when interest rates change they have an exponential effect. That’s why ARM mortgages are perilous. The rate goes up a little, but your monthly payment goes up a lot. Ouch. Compounding is where you’ll meet the non-linear exponential.
On the savings side, a small boost in your net yield can have a big effect on your retirement fund. Seemingly trivial expense ratios in a mutual fund have out-sized impacts on the amount you take into retirement. Dollar-cost average works it magic as you add a little bit of savings every month and they add up over years.
Your retirement depends upon money earned through compounding.
I could stop here. Perhaps I should just talk about interest and dividends.
Or maybe I must NOT stop here.
Other aspects of life are subject to compounding. Let’s suppose you figure out a way to become 1% more efficient in the way you use energy to heat or cool your house. So what? That’s a trivial amount. But suppose you find another 1% tomorrow. And another 1% the day after that.
Consider nation states like the US, the UK, China and Argentina. A few centuries ago the US was a howling wilderness and China was the richest nation on the planet. In my lifetime that was reversed as the US became an economic hegemon and Mao’s China was an economic basket case.
The remarkable fact is that even the poorest of us are richer than the people living centuries ago. “But i don’t feel richer than Henry VIII.” Feelings notwithstanding we are. Thank you compounding.
I hope that everyone tomorrow is richer and happier than they are today. But suppose the US enjoys a growth rate of 2% whereas China experiences an economic growth rate of 5%. (I am not an economist, so these percentages are completely fictitious.) Over the last few years China has been doing good-for-business things whereas the US has been doing bad-for-business things. Economic growth goes faster or slower as the weights handicapping it are taken off or put on.
Building from any starting point, it won’t take more than a few years of compounding for the Chinese economy to exceed the US economy.
We see “old money” countries like the UK whose standard of living is lower than all but one of the United States. We also see “new money” countries like Singapore who have emerged from 3rd world colonial status to exceed the USA’s standard of living. Nobody lost money. It’s just that poorer countries grew more slowly and were overtaken. Compounding the growth of just one or two percentage points creates the income inequality we see.
Here’s another example of compounding: Suppose you put out a novel and upload it to Amazon. It should attract an audience of fans who’ll buy it. And suppose you put out a 2nd novel. It will attract repeat business from fans of the 1st novel, and sales of the 2nd novel will boost sales of the 1st. Repeat this with a 3rd novel. It will boost sales of 1st and 2nd novels, and the 1st and 2nd novel buyers will have a 3rd reason to buy your product. Even if none of these titles are blockbuster best-sellers, the accumulated sales of each new novel compounded by the sales of previous novels will multiply seemingly insignificant royalties into a nontrivial income stream.
Consider the portfolio of skills you bring to your work. Let’s suppose that you purpose to add one skill every three months. Soon you’ll discover not just that you’ve piled up a fair number of skills, but also that using two in combination will create more value than either one alone. Every time you hear “the whole is greater than the sum of its parts.”
And if you are in the marketplace and have people following your lead, you have a “tribe” as Seth Godin would term it. Each additional member to your tribe increases the whole by more than what s/he brings to it, but by the network-effects of multiple people acting in concert.
You’ll note that I’ve conflated “compounding” and “network effects” the two ideas are different in that the first describes a thing that accumulates and builds on itself over time. The second is less descriptive and more explanatory. We can see why gains compound through the network effects of today’s gains working with yesterdays’ and the days before. These aren’t separate as much as distinct notions.
But they have one thing in common: time. Consistent effort to gain something: savings, network, fitness, good habits, strength of character will be rewarded over time provided that build success on success. Like the gravity that cannot overcome the double-sided tape on my TV cabinet overnight, but that wins over the course of several months, your efforts may seem small in the context of today, but will loom larger and larger the longer you pursue them.