Compounding – The Magic Of A Long-Term Mindset And Delayed Gratification
“Compound interest is the eight wonder of the world. He who understands it, earns it….he who doesn’t, pays it”
-Albert Einstein
Presumably, Albert Einstein said the words above, and likewise, Benjamin Franklin said that time is money. Unfortunately, we seem to forget these very simple principles when it comes to most decision-making – be it learning, investing, or in everyday life. Compounding comes in many fields as long as you’re agnostic, adaptive, open, and truthful to yourself, and a student for life. This way you compound both knowledge and wealth.
This article aims to illustrate investment compounding with some simple examples. Put short, you need three variables to make money investing: capital, return, and time. In this article, you will learn about the importance of return and time.
Why are we so slow in recognizing the effects of compounding? Most likely because the benefit of compounding is not immediate, but gradual. A boat sailing one degree off-course will over short distances hardly be noticeable, but over long distances, the mistake compounds and the boat misses its destination completely.
Compounding requires time and delayed gratification, often lots of it. Most people would rather have one marshmallow today than two in the future. Furthermore, we tend to think in linear terms and not appreciate the effort that can be sustained by thinking long-term.
The article does not cover the third element, capital (and how to get it). Capital is of course very important, after all, it’s the first seed you need in order to create financial wealth. But, as you will learn in this article, time is usually more important than a bigger amount of capital.
CAGR
CAGR is a term you often read about when you study investing and returns. It’s an abbreviation for compound annual growth rate and is used to “measure” the rate of growth. It’s not an arithmetic mean but the geometrical return from the beginning to the result (and is always different from the arithmetic average).
What is compounding?
Compounding is best illustrated by the snowball effect, something I believe most of us have experienced: as you roll a small snowball in wet snow it grows bigger for each turn.
Compounding in the investment world works exactly the same:
If you invest 100 at a 10% return, you have 110 at year’s end. If you don’t reinvest those 10 you earned, then the return in year 2 is also 10%, and you have 120.
However, if you reinvest those 10 you earn, you make 110 times 10% in year 2: 11 (the interest on the interest). That means you have 121 after two years, not 120 as you would in a non-compounding scenario:
| Year | Return % | Accumulated capital |
| 1 | 10 | 110 |
| 2 | 10 | 120 |
| 3 | 10 | 130 |
| 4 | 10 | 140 |
| 5 | 10 | 150 |
| 6 | 10 | 160 |
| 7 | 10 | 170 |
| 8 | 10 | 180 |
| 9 | 10 | 190 |
| 10 | 10 | 200 |
But if you reinvest the previous year’s return, it grows much faster:
| Year | Return % | Accumulated capital |
| 1 | 10 | 110 |
| 2 | 10 | 121 |
| 3 | 10 | 133 |
| 4 | 10 | 146 |
| 5 | 10 | 161 |
| 6 | 10 | 177 |
| 7 | 10 | 195 |
| 8 | 10 | 214 |
| 9 | 10 | 236 |
| 10 | 10 | 259 |
The difference is best visualized with a graph:
By now you have probably realized that the main factor for long-term financial wealth is how you invest the “earnings”/returns, not the initial principal. Because of the snowball effect, it’s the marginal rate of return you get on the reinvested capital that is important. I have covered this topic before in an article about dividends/marginal rate of return.
What happens if you let those 100 compound over many years?
