Compounding - 8th Wonder of the Universe

I’ve recently become very fascinated with this idea of compounding. It reminds me of the classic school maths question of simple interest vs compound interest. You know how it goes. Stuffy exam hall, sun beaming in through the windows, the guy next to you with the squeaky desk that makes you want to get up and throw him out of his chair every time he starts rubbing out one of his answers:

14) Bill has £100 to invest. He gets two offers from different banks. One is for 10% per year simple interest over 10 years. The other is for 5% compound interest over 10 years. Which should he go for?

It’s kind of an artificial question, because they’re not including other options like stocks, or taking into account how much short-term debt Bill may have built up on his credit cards chasing women and living the high-life. But this deceptively simple question touches upon one of the most interesting things about living itself. The forces of compounding.

Another way to look at it, is what are called feedback loops. The term comes from the unpleasant sound you get by holding a microphone too close to a loudspeaker. The microphone picks up sound energy, converts it to electrical signals, feeds that signal to the speaker, which amplifies it and then converts it back to sound energy, which feeds the microphone etc. Etc. We have A feeding B, and B feeding A. This feedback loop then compounds and rapidly escalates the noise to the ‘who the bloody hell is doing that?’ level.

Ok so back to the maths. Simply put, this is the difference between an arithmetic (or linear) progression or a geometric (or exponential) progression. Linear progressions are repeatedly adding the same amount over and over again. Something like this:

3 + 3 + 3 + 3 + 3 + 3...

And if you plot this on a graph you get a straight line. A geometric progression is repeatedly multiplying by the same amount, so something like

3 X 3 X 3 X 3 ...

And if you plot this on a graph you get a nice upwards curve. But this curve starts off slow, then gets faster and faster and faster. The effects feed back on each other, and they compound to produce a VERY large effect.

Ok that’s the end of the maths I promise. But the maths is important nonetheless, to understand the principle we then apply to other areas. Another comment that has stuck in my mind recently is one from Grant Cardone – “middle class people learn how to add, wealthy people learn how to multiply”. And I have a feeling he’s driving at the same principle here.

Let’s look at some interesting feedback loops I’ve observed or even experienced myself. I was actually pretty decent at maths when I was at school (and went on to get a Masters Degree as well!) but I was always a bit miffed at how I was perceived as ‘gifted’, or ‘lucky’ by other people in my class. They couldn’t understand how I often knew the right answers. What they didn’t know is in my free time at home, I would read the textbooks we were given, or try things and be actively pursuing the knowledge in my own free time.

I did, basically, work harder than they did, and ultimately got the rewards of that. But I think compounding is an important factor. You see, when you first start learning a subject, it is difficult. The difficulty of it makes you feel stupid, serves to demotivate you, and that leads to people investing less time and effort into understanding the subject.

This lack of time and effort invested only serves to cement the incompetence, which then produces bad results and re-inforces the lower levels of motivation. It’s a negative feedback loop, and one that can be hard to get out of. I should know, I’ve tutored numerous students in this situation with maths. There is a way out however, and the way out is to begin a positive feedback that will counter the negative one. The solution is one I got from L. Ron Hubbard’s book, “The Problems of Work”, in which he says to find ONE thing, no matter how simple, that someone can do, and stick with that until they can do it.

That sense of accomplishment they get from mastering one task, serves to motivate them to try something else. And you then stick with that one thing until they get that. Then the confidence builds, and the person is on the road to recovery. They are on a positive feedback loop that will pick up momentum and carry them over the line.

I think life is like this. I think everything we do has feedback loops. Things start slow, so people don’t seem to feel there is any progress. What they don’t understand is they are starting off at a 1% growth rate on a tiny principle of $25.

Small multipliers of small amounts don’t result in much change. But, over time, feedback loops develop and start to build powerful forces that cannot be stopped. Let’s take a simple example. Let’s say there is someone down on their luck, working a minimum wage job with no opportunities.

One solution to this problem, is to get down about it, lose hope, start drinking and smoking, and give up on themselves. Ten years down the line and this person could be a total mess. Drinking is expensive, it impacts your health and mental health, which in turn makes it harder to take advantage of opportunities. The added expense means they haven’t saved any money, can’t invest in things that could create opportunities for themselves. Etc. Etc. They can quickly get into a negative feedback loop and traps them in a hell-hole of a life.

I’m actually writing this article sat in a public library right now surrounded by books. Each and every one of them is free, all you have to do is walk in and start reading.

Imagine this same person, instead of going for a drink every evening after work, came to the library to read for 1 hour. That’s all, 1 hour a day. And then let’s say 5 hours over the weekend. Doesn’t cost any money, doesn’t cost anything they don’t have, just a bit of their time. Well that’s 10 hours a week, or 500 hours a year. So over that same decade that would be 5000 of time invested in their own mind and knowledge.

I would be very surprised if that person hadn’t learned something new and valuable they can take into the market place and make more money with it. Very surprised. And all that money they didn’t spend on drink, could be invested in a nice stock portfolio worth $50,000-$100,000 earning them passive dividend income.

Gary Vee always talks about patience, and I think this is also what he might be driving at. Patience to recognise that feedback loops take time to develop. I think a vital part of success in life is to recognise negative feedback loops when they develop and nip them in the bud before they grow out of control. Another key ingredient is to plant seeds and invest in positive feedback loops, and have the patience to wait until they bear fruit, then reinvest the results back into the feedback loop.

I think the ingredients to success are well known. Most people know they should exercise more, drink less, eat better, control their expenses better, learn more, work harder, be kinder to people, improve their attitude. What I suspect happens to a lot of people, is they get 1 month into a project like that, don’t see any results, and throw in the towel. And that is why they are not successful. The do not understand compounding and how it works. It’s like a child planting a seed, then coming back every ten minutes to see how it’s getting along. And at the end of the day concluding that the seeds were no good and throwing them, and the soil, in the bin.

Now, we have to guard against one potential trap. And that is being SO patient with something that actually has very little positive benefit. Don’t invest $1000 in a bank account paying 1.00000001% interest. It will take a million years before you see the benefits of that investment! Luckily for us, we don’t have to take those kind of risks. Like I said, the ingredients to success are well known. Educate yourself, push yourself, keep good company, eat well, take care of yourself, exercise discipline and self-control, work hard, keep your spirits up, help other people. Keep doing these things and in 10 years time you are almost guaranteed success. The compounding effect will be too strong to be undone.

(Published on 14 Nov 2019)