When we plan to improve ourselves, we pursue dramatic changes, committing to goals like, “Running 10 km starting tomorrow” when we haven’t even been taking daily strolls. Or, “Waking up at 6 everyday” when we’ve been sleeping till 9 all our life. This approach is unsustainable. If you don’t believe me, make a list of the promises you’ve made yourself over the years, and see how many of them you’ve kept.
A better approach is to go for small, with incremental improvements that add up over time—results that compound.
Investor Morgan Housel is one of the best thinkers of our times. He tells the following story to explain how compounding works. It’s about how ice age happened.
There have been at least 5 major ice ages in the earth’s history. The whole earth was covered in 3–4 km thick ice sheets. If you were to answer how this happened, you would most likely say long and cold winters led to that. That’s incorrect. As unintuitive as it sounds, instead of cold winters, it was moderately cool summers that led to ice age.
It starts when one fine summer it didn’t get warm enough to melt away previous winter’s snow. The leftover snow makes it easier for more snow to accumulate in the next summer which is relatively cooler as well. Now we’ve got all these leftover snow which attracts even more snow that accumulate the following winter. Give it a few hundred years, and a seasonal snowpack grows into a continental ice sheet, and the whole earth gets covered in snow.
The same happens in reverse. An orbital tilt lets more sunlight in, which increases temperature, melts more snow one fine summer, which prevents more gathering of snow the next year, and so on.
You start with one cool summer that no one would think anything of, and suddenly the earth gets covered in thick ice. It’s not about how much snow is gathered a season. It’s more about how much lasts. The takeaway is that you don’t need big forces like long and hard winters to create tremendous results of this scale.
Similarly, Warren Buffett is a phenomenal investor. But most people miss the point that he’s been doing serious investing since age 10. He wished he started earlier.
He has been compounding returns for 75 years. With his track record, had he started investing at 30, and retired at 60, few people would have heard of him.
Interestingly, Buffet maybe the richest investor of all time, but he’s certainly not the greatest—not when he is measured by his annual returns. There are several hedge fund managers who have compounded 2x or 3x times Buffett’s rate, but their net worth is not even close to Buffett. Because most of them haven’t been in business for more than a few decades decade. Time isn’t on their side.
Had Buffett spent his twenties travelling and soul searching; had he retired at the age of 60 to spend time with this grand kids, with 22% annual returns, he would have made about $12 million in total—which is 99.9% less than his actual net worth of $85 billion. Even though his skill is investment, Buffett’s secret is time.
Warren Buffett is the ultimate example. If you manage to have minimum returns, and not to lose money for a long time, you are bound to get rich. The trick is to make time your ally so that the longer you play the better your prospects become.
Paul Graham, the founder of Y Combinator, is fond of saying, “A startup is a company designed to grow fast.” Most founders take this at face value, and focus on growth at breakneck speed. But what PG talks about is consistent growth that compound with time, not one time flukes.
A company that grows 1% a week will grow 1.7x a year, whereas a company that grows 5% a week will grow 12.6x. But a company that grows at 10% a week will grow 142.0x a year. Tiny changes in the present compound to massive differences in future.
However, most startups fail in the first 2 years. They focus on growth at the expense of survival. But you cannot grow if you aren’t in business anymore. 10% a week might look tiny in the beginning, but it’s enough for compound interest to kick in and takeover after an initial slog. You don’t need maximum efficiency. You don’t need maximum returns. You don’t need maximum productivity. You need the bare minimum that lets you play the game long enough to have an edge in the future.
Linear growth is intuitive. If I ask you to calculate 5+5+5+5+5+5+5+5+5 in your head, you can do it in a few seconds. If I ask you to calculate 5×5×5×5×5×5×5×5×5, your head will explode. Calculating exponential growth requires a calculator. Paul Graham writes:
Our ancestors must rarely have encountered cases of exponential growth, because our intuitions are no guide here. What happens to fast growing startups tends to surprise even the founders.
Compounding does not work for the first 2–5 years, but it works for the next 20–50 years. Warren Buffett added most of this wealth after his 65th birthday. Most people don’t have that kind of patience.
The counterintuitiveness of compounding is responsible for the majority of disappointing trades, bad strategies, and successful investing attempts.
Compound Thinking is thinking in terms of compounding and exponential growth. Since it is not intuitive, majority fail to notice it—even the smartest of the lot. That’s why it gives you an unfair advantage. It’s the most powerful open secret weapon.
As Morgan Housel writes:
Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.