Compounding is the addition of interest to a fixed sum, leading to exponential gains. By reinvesting interest in a fixed sum, one earns the combined amount in the next period, which continues exponentially over time — interest earned on interest.
While compound interest is based in finance, compounding has applications in several disciplines. The effect is quantifiable when building wealth and observable in relationships, health, and, most importantly, knowledge. Reinvesting time and effort in something increases its value and can be a force multiplier.
Why Use It
Exponential gains in personal and professional life are often rooted in compounding. Albert Einstein famously noted, “Compound interest is the eighth wonder of the world.”
The power of compounding is in actualizing gains via effort over a long period. Regardless of the effort’s size, driving steady progress is the key.
It is human nature to overestimate short-term gains and underestimate long-term ones. What is possible in one year is much different than five and ten years.
When to Use It
Compounding’s “snowball effect” exhibits how small gains significantly affect the future.
Wealth generation portrays the opportunity well:
- Say you invest $2K at 5% compounding interest for 40 years; you will have $14.5K.
- Then say you added $2K a year to that principal sum, you would end with $256K.
- Over that time, you would have contributed $82K total, but the value of that lump sum of money is significant.
- If you had an annual salary of $75K, it would be worth ~3.5 years of work.
Each month, a small investment becomes a critical part of increasing your options and freedom later. With that money, you could make a large purchase, spend time investigating your interests, or anything that suits you. In this respect, the value of compounding interest is in leveraging it for gains elsewhere or delivering the security required to take more chances.
On the positive side, there is wealth generation, but there’s a converse effect on poor decision-making. For example, choosing a career path that does not match your interests can lead to better opportunities in a field not aligned with your life goals.
How to Use It
To compound anything, the principal must be more than zero (nothing doesn’t compound). It is as true in finance as in knowledge and relationships: a base must be set for learning and trust in friendships.
How does knowledge compound? Information is easier to understand when you have expertise on the subject. When you re-read books, more connections are made to the source material and deliver a broader understanding. Take two people in an industry where one is new and the other with many years of experience. They are each given a book with advanced concepts. Who is most likely going to understand it better?
Calculating compound interest requires several considerations:
- The principal is the amount you invest at the start.
- Interest is the rate you earn. The higher the rate, the more you make.
- Frequency is the interval interest compounds, daily, monthly, quarterly, or annually.
- Duration is the length of time you will leave an amount to compound.
- Deposits are the amount of money you add to the principal in addition to reinvesting interest.
Mathematically speaking, the formula is as follows: A = P(1 + r/n)nt
- A is the Accrued amount (principal + interest)
- P is the Principal amount
- r is the annual nominal interest rate as a decimal
- n is the number of compounding periods per unit of time
- t is the time in decimal years
When choosing to employ the concept, pay special attention to frequency. It is the pace at which compounding occurs and affects gains directly. The more often interest compounds, the more noteworthy the accrued amount becomes.
How to Misuse It
Compound interest differs from simple interest, where any interest made is not reinvested.
Similarly, it is easily confused with marginal gains, where minor incremental improvements over time add up. Marginal gains are used widely for self-improvement and sports.
The key difference when compounding is that any value gained is reinvested in the base, and the next incremental improvement is made from that new and larger base.
Compounding consistent incremental progress results in exponential growth. It is playing the long game in a society that seeks quick wins and overnight success.
Instead of choosing transformational and immediate change, choose small investments and reinvest in them. Utilize a longer time horizon as your greatest ally in finding and succeeding at path creation. Take advantage of the rewards compounding delivers, and make an outcome the next jumping-off point to reach greater heights.
Where it Came From
Roman law and common laws around the time of ancient Rome condemned the use of compound interest by lenders as usury. Later, Francesco Balducci Pegolotti developed a compound interest table in his 1340 book, “Practica della mercatura.” In 1494, Luca Pacioli created the Rule of 72, which delineated how compound interest should be calculated. Richard Witt popularized the use of compound interest in 1613 with his book, “Arithmeticall Questions,” which brought the concept front and center with over one hundred examples.
What Are Mental Models?
Mental models are thinking tools that help guide and shape our perceptions of the world. They simplify complexity so we can understand life better, make decisions confidently, and solve problems.