Why compounding works and how can we use it in our life? 📈(The Mental Model from Compound Interest)

“Compounding is the 8th wonder of the world, those who understand it earn it, those who don’t understand it pay it” – Albert Einstein

It’s disputed whether Einstein actually ever said this or not. But the quote is still very powerful and gets the message across.

It’s imperative that we understand this crucial metal model and learn to apply it in our day to day life.

Let’s talk about compounding-

What is Compounding?

Compounding is a mathematical principle that comes from the idea of compound interest → interest accruing interest.

It simply means that when you earn $1 interest on the $10 in your bank account. You can put that dollar back in to the account and now $11 will earn you $1.1 interest.

And the cycle will keep going as long as you keep reinvesting the interest.

With time, your tiny principle will snowball into a large sum.

There are two important concepts to care about here –

  1. Reinvestment – Basically not interrupting the compounding process. Adding on to the initial corpus to see it grow.
  2. Time – Giving the process time. All good things in life take time. The growth is slow initially, but as the interest adds up it can get exponential over time.

If you are persistent and patient, compounding can do wonders for you.

And this is not just about money.

Compounding as a mental model works in all areas of life – be it health, relationships or knowledge. And it works through our routines and habits.

Habits are the engine of compounding. With healthy financial, physical, mental and emotional habits you can reap the benefits of compounding to live a better life.

Intuitively we do understand it, let’s see some applications of compounding to make the benefits obvious –


Practical Applications of Compounding

Finance

Finance has the most obvious application of compounding but there are a few nuances we must cover.

At some level I think all of us understand the importance of letting your investments compound.

You invest in stocks, bonds, mutual funds.

You do it regularly, over a long period of time. You don’t touch your investments, not take them out unnecessarily.

Then you are bound to see compounding gains.

This graph explains the idea.

The Magic of Compounding
The Magic Of Compounding

A little nuance

But reality is hardly ever as smooth as theoretical graphs.

It’s important to realize that compounding doesn’t always work.

It’s not that if you keep reinvesting and never take your money out then you are guaranteed exponential returns.

Financial markets closely mirror real life – including the ups, downs and the uncertainties.

Which means that just like in real life you can die of a freak accident within the next 27 minutes, in financial markets you can lose all your money in the next 27 seconds.

This graph tells a story

S&P 500 Index
S&P 500 Index

This is the S&P 500 – The index of the top 500 US companies in the stock market.

Notice the steep fall in 2008-09 and then again in 2020.

They were because of the 2008 financial crisis and the COVID-19 pandemic respectively.

On a broader level, this graph comes close the previous graph and compounding seems to work in the long run.

But at a granular level, in the day to day operations of the markets, compounding hardly ever plays a role.

As we go from risky to safe financial instruments, compounding seems to get stronger.

It’s because of the certainty of returns associated with each type of instrument.

More certainty = less return in short term but more chances of compounding in long term.

So what should your approach be?

This is not investment advice, but many experts talk about a barbell approach to investing.

It basically means that a small part of your savings are invested in extremely risky instruments and a larger part is invested in extremely safe instruments.

That way you can enjoy the spiky nature of volatile instruments as well as the certainty and compounding power of stable instruments.


Relationships

Compounding works in relationships as well.

In romantic as well as business relationships.

The “principal” and “interest” in this context are the regular acts of kindness the two partners indulge in.

There is of course friction in every relationship. But if two people can manage to keep their relationship net positive everyday, and add on to it just a little, then over years compounding can wildly benefit both of them.

In business – the longer you have been working with someone, the easier it is to trust them.

Naval Ravikant makes an excellent point about compounding in business relationships👇

“If I’m doing a deal with someone I’ve worked with for 20 years and there is mutual trust, we don’t have to read the legal contracts. Maybe we don’t even need to create legal contracts; maybe we can do it with a handshake. That kind of trust makes it very easy to do business.”

In romantic relationships, as two people grow old together, they understand each other better.

They get used to each other, they trust each other a lot more than they can trust anyone else.

And with such thriving, compounding relationship it becomes easier to deal with the toughest challenges in life – be it raising children, changing careers, or dealing with the loss of loved ones.

Of course, the opposite of it is an unhealthy relationship with lack of trust and filled with insecurity.

The longer you stay in such a relationship, the worse your life will get. That’s negative compounding. (more on negative compounding in a bit)

This model can be applied when you are evaluating any relationship.

Ask yourself a simple question –

“is the relationship gaining net positive trust and affection everyday or not?”

if the answer is no for a continuous period of time, you know you will never see compounding kick in.

No matter the amount of time you spend with the person.

But if the answer is yes, you can rest assured that the long term health of the relationship is sorted.

You will reap the benefits of compounding.


Health

The impact of compounding is quite obvious in your physical health.

You just have to do 10 pushups a day for 30 days in a row to see the impact.

Every subsequent pushup becomes easier with time, and you can feel the change in your body during that time.

Doing 10 pushups a day for the first time in your life can seem daunting, but after a few days, you can start to do more than 10 pushups without any difficulty.

That’s because our body adjusts to the new stress, it builds muscle to deal with it, it builds strength, and gets conditioned.

With time, it becomes easier and you can choose to do more.

You can choose to reinvest the interest back into the principal.

Anyone who has gone from being unfit to fit in life knows this – it’s not about how intense each work out it, it’s about how many consecutive workouts you can string together.

If you can maintain a streak long enough, and increase the intensity even just a little, you will see tremendous results in your body.

That’s how professional athletes train as well.

Be it Michael Phelps or Usain Bolt.

They have well designed workout routines that they stick to for long periods of time.

Their body adjusts, grows and becomes accustomed to the new circumstances – be it swimming or sprinting.

And on race day, they reap the benefits of compounding by displaying just how good they are than the rest of the world.


Knowledge

Knowledge also builds upon itself and compounds. The most obvious example is the way our math curriculum is designed.

Arithmetic leads to trigonometry, trigonometry leads to calculus.

But it’s not a straight line.

The jump from Trigonometry to Calculus is so high that it can only be achieved if we have spent countless hours building our knowledge on Arithmetic and Trigonometry.

We can only understand Calculus if we have compounded our knowledge of the previous two stages.

But if for some reason, the basic foundational blocks are not in place, then we can never climb the ladder of mathematics.

Essentially, we need the interest of knowledge to be reinvested.

We have to use new knowledge to gain more knowledge and not interrupt the streak. Only then will be able to reach the top.


Wisdom

Junk in Junk Out, Quality in Quality out.

This is true for our physical health as well as our mental health.

And it’s true for our ability to think critically.

Even if we have compounded knowledge, we can’t take wise decisions if we don’t apply the knowledge.

And the more we apply a piece of knowledge, the wiser we get at it.

Art museum curators can detect a fake painting in a blink of an eye.

That’s not because they have some extra knowledge about the paintings than the rest of us. But because they have been applying that same knowledge for decades. They have internalized it to such an extent that it is a part of their subconscious mind.

That’s why sometimes they even proclaim a painting is fake without being able to give a solid explanation immediately.

Malcolm Gladwell’s book Blink goes deeper into this idea.

We can see that compounding works when we apply the same knowledge over and over again to a problem for a long period of time.

We become “experts” at it.


Negative compounding

One last thing that must be addressed is the idea of negative compounding.

Negative compounding happens when you keep drawing from your bank account and never let the sum compound.

Eventually you will run out of money and even go in debt.

And then, the debt will compound against you.

That also happens in finance, health, relationships, Knowledge and Wisdom.

The poorer your health is, the more difficult it will be for you to get back in shape.

Poor eating habits compound over time resulting in an addiction to carbs and sugar.

A bad relationship, with emotional wounds, if not healed and brought back on track, will then go from bad to worse and impact the emotional well being of both partners.

The best way to beat negative compounding is to not fall into it.

And if you do, then you must start reversing is as soon as you realize it.


Conclusion

Compounding is a powerful mental model.

With applications far beyond finance or mathematics.

Compounding will work like a snowball, unremarkable at first, but massive towards the end. And it works in the negative as well positive directions.

The compounding snowball
The Compounding Snowball

Whenever you see someone get exponential gains or losses, you can trace their journey back and see the effect of compounding in their life.

The two most important aspects of compounding that we must keep in mind – reinvestment and time.

If we are patient and persistent, we can watch compounding run wild.


Related

What Are Mental Models & Why Are They Important (With A Simple Example)


Thank you for reading🙏

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