Compounding

"All the returns in life, whether in wealth, relationships, or knowledge, come from compound interest " ~ Naval Ravikant

     

Above we can see how the richest investor in the world compounded his wealth 

         Compound interest has an impact on all of our lives. The formula for compound interest is simple               and well known it is

                                   P= (1+R/100)^n

          P-Principal, R- Rate of interest, n- no of years

         We usually assume that compound interest is just a formula to apply in math which doesn't have any use for anything in the real world. Compounding is so much more than just a formula though. First, let's see what impact compounding has on wealth creation or why it is helpful in becoming rich.

How Compounding helps create wealth

Let's begin with an example, this example really blew my mind so I hope it blows your mind as well. In the very famous book 'The Psychology of money' written. by Morgan Housel, he wrote a wonderful example about Warren Buffet and Jim Simons. He said that Buffet's skill may be investing but his secret is time. Why does he say this? He then gives an example of how Buffet is the richest investor of all time but he is not the greatest, Jim Simons who is the founder of a hedge fund named Renaissance Technologies has got an average annual return of 66% since 1988. Warren Buffet on the other hand has got an average annual return of 22% since 1941. Even though Jim Simons compounds his money at a higher rate he is 75% less rich than Warren Buffet. Time plays an underrated role in compounding and people often choose to go after a higher rate of return instead of surviving for a longer time. (Skin in the game). Now if Simons had invested for as long as Buffet and generated the same amount of return then he would have $63,900,781,780,160,000 compared to his $21 billion

Now let's look at some of the lesser-known powers of compounding :

Asymmetric Power of Compounding

Compounding is convex on the upside and concaves on the downside. This means that compounding on the upside can give you extraordinary returns, whereas on the downside no matter how bad your negative returns are you cannot go below or at zero. 

Positive: (1+0.20)^10=6.19

Negative (1-0.20)^10=0.01

This basically shows us that there is no limit to how much you can gain but there is a limit to how much you can lose.

Compounding allows you to be wrong 50% of the times

This is closely interrelated with the last subtopic. Let's say you have invested in 2 stocks and you have put the same amount of money in both those stocks respectively. Now let's say after 10 years you get an average annual 26% return on one stock and a -26% return on the other stock. Even though you got one stock terribly wrong and it compounded negatively your average return after 10 years will be 17.6% which is still really high and can help you in creating wealth. This is possible because compounding on the downside is concave and has a limit.

Let's see how compounding affects other aspects of our lives.

How Compounding helps in sports

As someone who loves and plays sports since the age of five/six. I only realised recently when I understood what compounding is, how much impact it has had on my sports career and normal life. Now let's see how compounding helps in becoming better at sports let's say you are a football player and you want to improve your free kicks. You go to the ground and take 10 free kicks and score let's say 2/10.  Now you want to improve so you practice every day and slowly about after a month you will probably become better and started scoring 6,7/10 free kicks. This progression is compounding. You can become better at the gym as well if you use compounding. If you can do 5 push-ups just keep adding only one push up every week so that you keep improving, if you follow this at the end of the year you will be able to do 57 push-ups. 

How Compounding helps in health

You can use compounding to get rid of bad habits as well as form new ones. If you want to eat healthier just reduce whatever your junk food intake is by a little bit ( for example if you eat junk food twice a week try reducing it to one and then to once in two weeks and so on..). If you are not active start slow and small start with walking for a small distance then keep increasing the distance then start running and high-intensity exercises as time goes on.