If I could start my investing journey over again, right from the beginning, there’s one single thing I would make my focus: compounding. Success is a process of continuous compounding. We live in an inpatient world, surrounded by utilities that promise to give us instant gratification.
Yet the power of compounding, over a certain period of time, remains massively under-rated and misunderstood. We often think about total returns in a finite period of time — for example making 20% in a year.
But this is a trap, the real game of investment (assets or in business) is about finding exposure to something with scale that can continuously grow over a long period of time.
Putting 1% into perspective
A 1% return sounds insignificant, most people won’t bother. Yet there’s a difference between 1% per annum and 1% per day. Compounding 1% per day over a year yields a return of 3,778%. If I can lift 1% more each day at the gym, compared to the previous day, in theory I should be able to lift 38x my initial starting weight in one year.
Lifting weights doesn’t scale as well as investments because as a human being, there is only so much I can physically lift given my body’s limitations. Thankfully others things aren’t limited by the laws of physics. My personal development as a business leader, to my team and clients, has no limitation. My love towards my family is similar. There’s nothing stopping me from becoming 1% better each day than the previous day on an ongoing basis, over a long period of time.
My investment portfolio also has no limitation, there’s no law that says I can only have a certain amount of dollars beyond which everything else is cancelled out.
Amazon is a perfect example of incremental returns, compounded by great management, over a long period of time. When Bezos started the business, he was doing things much differently to today. But the mantra of small improvements, compounded over a long period of time, has seen it become a US$1.6 trillion business.
Bezos has an entire philosophy called “Day 1” which you can read about here.
The compounding test formula
Compounding works best in concepts that scale. There are two things we need for big results:
1) A concept with infinite upside
2) A process of consistency, so we can achieve returns over a long period of time
Real estate is another great example. There’s no limit to what an house or apartment price could be in $ terms in the future. There are limiting factors for price growth, limit demand, supply, building costs etc. But there is no legislated ceiling.
Real estate in major metropolitan cities can deliver consistent returns, even if they are small on an annualised basis, because markets in large cities are larger and more efficient.
If you’re patient with good quality real estate, a 5% annual compounded return results in 265% in 20 years. Considering most residential real estate investment involves debt, a 20% deposit will grow by 13.3x over the same period.
To put it simply, a $100k deposit on a $500k apartment will grow to $1.3m in equity over a 20 year period if the apartment grows by only 5% per annum, compounded. If I add to my investment with periodic additional investments, as opposed to paying down debt, my compounded return across the portfolio becomes even greater.
It’s the same with stocks and most other digital assets assuming they have longevity and infinite upside potential.
Run the numbers properly
One of the things I’ve recently been contemplating is how many successful people in business or investing I know who aren’t good with numbers. It’s an anecdote, but I generally tend to see a strong correlation between investment success and having careful regard or an understanding of mathematics.
Sure, there’s always going to be people that suck at math and do well in life. But business and investing (perhaps even epidemiology) is really about finding trends in numbers and scaling over a certain periods of time.
My focus though is on the consistent performers, those who build big things from small beginnings across the business and investment. Understanding the difference between a 20% pa return vs 1.6% compounded monthly over a 20 year horizon, is just the margin of error that can fundamentally change your quality of life and decision making framework.
If you stop at general math, then you will only make general money. –Snoop Dogg
It took me a while to appreciate compounding, to think beyond the short term and organise everything in the context of incremental returns over a period of time. But now that I get it and live it, my life is completely changed.
Here’s a simple compounding interest calculator, play with it. Bookmark it. Figure out what you want in life, what works for you and then reverse engineer the annual return you need over the time you have to pick the right investments. You’ll be surprised at how easy it becomes once you get the numbers in order.
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