Investopedia defines compounding as “the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.”
In practical terms, investing $100 at 6% interest in beginning of year 1 will yield $6 at the end of the year for a total of $106. In the next year that $106 at 6% interest will generate $6.36 of interest for a total of $112.36. Notice how without adding any additional money the interest generated went from $6 to $6.36. This is compounding at work and its power is exponential.
Why is it important?
Understanding the power of compounding is as important to your personal life as it is to businesses around the world. Despite being a relatively simple concept, the true power of compounding is often underestimated.
Business Insider has compiled charts which show just how powerful compounding can be, but these shouldn’t surprise you if you understand the power of the concept.
Borrowing one chart from JP Morgan to illustrate, the best strategy hands down is to start early and save consistently. Starting early in particular has a drastic impact in the end result. Comparing Susan and Bill below you can see that Susan is in a better place saving $5,000 between the ages of 25 and 35 investing only $50,000 than Bill if he invests $5,000 between the ages of 35 and 65, triple the amount that Susan invested.
How can you apply it?
Warren Buffet has written a number of essays on the power of compounding in personal finance and probably my favorite example is from his 1965 letter to shareholders where he writes:
“The saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.”
Compounding can be applied in several dimensions other than finance.
Stephen Cohen, co-founder of Palantir, applies it to the realm of intelligence:
We tend to massively underestimate the compounding returns of intelligence. As humans, we need to solve big problems. If you graduate Stanford at 22 and Google recruits you, you’ll work a 9-to-5. It’s probably more like an 11-to-3 in terms of hard work. They’ll pay well. It’s relaxing. But what they are actually doing is paying you to accept a much lower intellectual growth rate. When you recognize that intelligence is compounding, the cost of that missing long-term compounding is enormous. They’re not giving you the best opportunity of your life. Then a scary thing can happen: You might realize one day that you’ve lost your competitive edge. You won’t be the best anymore. You won’t be able to fall in love with new stuff. Things are cushy where you are. You get complacent and stall. So, run your prospective engineering hires through that narrative. Then show them the alternative: working at your startup.
Frank Lio applies it to simple disciplines or errors over time:
Principle #1 – Simple Disciplines Repeated Over Time:
It is the simple disciplines (choices) in life that don’t seem to make any differences at all in the moment; however, repeated over time, the compounded effect makes all the difference in the world. Personal choices may be to take time daily to talk to a loved one, to show compassion to a colleague or report, to exercise, to meditate, to save money. In business, we employ continuous follow-up after every customer installation, product changes based on customer feedback and implementation, quality corrective actions.
Principle #2 – Simple Errors Repeated Over Time:
It is the simple errors in judgment that don’t seem to make any difference in the moment; however, repeated over time, the compounded effect makes all the difference in the world. Personal examples may be smoking, eating that daily bacon breakfast sandwich, skipping lunch or exercise. These are innocuous, seemingly innocent little “miscues” or transgressions. Businesses may decide to “go cheap” and skimp on customer service, allow more quality defects or cheaper parts in their product, a bank may continuously add fees, etc.
And Adam Miller applies it to startups and growth:
If there’s one theme that all of the greatest growth stories, be it Dropbox, Uber, or Airbnb, have in common it’s the rarely discussed topic of “compounding” growth. We all understand that users beget more users beget more users, but few stop to understand that the reasoning behind each customer’s decision to use a new product or service will differ.
And the list goes on and on…..