Einstein said that compound interest is the most powerful force in the universe. Compounding takes time, but it can provide a big boost to your finances.
Compounding: Simple, yet powerful
You really don’t know something well until you experience it first hand. I knew how compounding worked in theory. But over the years, I have been amazed at how compounding works in practice.
Compounding happens when your initial investment generates a return (profit). The profit then gets added to your investment – so now both your initial investment and the profit together can help you generate additional profits.
Below is a quote from the famous investor Charlie Munger, stating that compounding is powerful yet hard to attain. It is hard to leverage the full power of compounding because compounding takes a lot of time and patience.
For those of us who have patience, compounding can be a great ally on our financial journey.
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
The magic of compounding
There is an old fable that illustrates the power of compounding.
In ancient India, there was a king who was an enormous chess enthusiast. One day he challenged a wise sage for a game of chess. The sage was a skilled chess player and easily defeated the king. The king was impressed and offered the sage any reward he wanted.
The sage asked for grains of rice in the following manner: a single grain of rice on the first chess square, two grains of rice for the second square, four for the third, and so on….. basically doubling the number of grains of rice for the each of the following squares.
The king thought it was a small request and promptly asked his minister to fulfill it. A week later, the king inquired about the sage’s request. The minister replied that they were working on it. The king was surprised and asked his minister why it was taking so long.
The minister then explained the math behind the request. If you start adding all the grains of rice that the sage had requested: 1 + 2 + 4 + 8 + 16 + 32 + ……. once you get to the last square of the chessboard, you will need 18,446,744,073,709,551,615 grains of rice.
That is eighteen quintillion four hundred forty-six quadrillion, seven hundred forty-four trillion, seventy-three billion, seven hundred nine million, five hundred fifty-one thousand, six hundred and fifteen grains.
How much rice is that, really?
This fable illustrates how quickly tiny numbers 1,2,4,8,16… can compound to truly gigantic numbers.
To put it in perspective, if we take every grain of rice ever produced, we would still not be able to get to the number above. Even with the current global production levels, it would require about 2,000 years to fulfill the sage’s request.
Another way to look at it is – a grain of rice is approximately 0.2 inches long. Alpha Centaurus (our nearest star) is located 25,000,000,000,000 miles from Earth. If we align all these rice grains end to end, it would take us to Alpha Centaurus and back.
That is how much rice would be needed to fulfill the sage’s request!
Time and Patience – The ingredients for magic
While compounding is magical, it takes time to work its magic. I was able to successfully navigate the 2020 downturn without panicking / selling because I had given compounding many years before that to work its magic.
Initially the grains of rice 1 + 2 + 4 + 16 + 32 … do not seem large enough.
As you can see below, the line barely seems to move for the first several squares. The magic of compounding is happening all along, but the effect is felt towards the end. Only when you get to the later chessboard squares, the awesome power of compounding becomes clear.
Compounding and downturns
Compounding can help mitigate the effect of a downturn. The longer my portfolio compounded, the better I was able to deal with any downturn.
This may seem obvious, but it was instructive to see this play out in a downturn.
In March 2020, there was a sharp decline in stocks caused by the global pandemic. The market went down more than 30% in a matter of days.
Here is where compounding was beneficial. I had built up a portfolio over ten years, and hence I was in a much better position to withstand this drop.
The drop – big as it was – did not look that bad when seen over a longer time horizon.
Despite being down more than 30% in 2020, my portfolio was still up more than 100% since the start of the decade.
Not giving up
When I started my FI journey, the initial investments were relatively small. And the investment growth also did not seem that great. Watching it grow was like watching paint dry, and at that time, it would have been easy to give up.
Luckily, I persisted.
Those small beginnings have now given rise to a substantial investment portfolio.
No matter how small the initial investments are or how slow the initial growth is, it is important to persist. That is especially important in this age of instant gratification.
Related Article: The simple but ignored secret of Warren Buffett’s wealth: Time & Health
In conclusion
Compounding worked wonders on my FI journey. However, for compounding to work, time and patience are needed.
Give enough time for compounding to work its magic, and it will supercharge your finances.
All human power is a compound of time and patience.
Honore De Balzac
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