May 13, 2020

The Compounding Principle: A Smart Way to Maximize Your Gains

Along with scaling, the compounding principle is counter-intuitive.

While they are both simple concepts to grasp, people often underestimate their potential. Even when we understand that something grows exponentially, the numbers quickly get mind-boggling.

The fundamentals of the compounding principle

Let’s imagine you knew a way to start with a $1 stake and double it (you probably already do). If you did that twenty times, you would make a $20 profit. Now, let’s imagine you start with the same $1 stake and double your money twenty times again, but this time you reinvest your profits from each round into the following round, doubling your stake each time. How much money do you think you would end up with? Forty dollars? One hundred? One thousand? The actual answer is one million. Don’t believe me? Here’s the sequence:

1 > 2 > 4 > 8 > 16 > 32 > 64 > 128 > 256 > 512 > 1,024 > 2,048 > 4,096 > 8,192 > 16,384 > 32,768 > 65,536 > 131,072 > 262,144 > 524,288 > 1,048,576

Crazy, huh? What starts as a seemingly pedestrian rate of acceleration soon ramps up to result in huge numbers. That ramping is due to the compounding principle. Note that the rate of growth never changes; the number only ever doubles each from one step to the next. But, because the starting figure for each round continuously increases due to the compounding principle, the numbers grow at an ever-increasing pace.

This is why many people failed to anticipate the scale that COVID-19 would ultimately spread to, even though they were aware of the growth rate of the virus in its early days. Despite knowing that pandemics tend to spread exponentially, it was still hard to think far enough ahead to comprehend the implications of such compound-based growth.

It’s also why people make poor financial decisions. Consider again the wildly different outcomes of the two investment strategies outlined above; one yielding $20 and the other one a cool million. This is why smart people reinvest profits rather than take them in their pockets. Compounding positive returns is the key to growth, and will significantly increase your wealth in the long run.

Compound investing

When you open a brokerage account to invest in stocks, you are given two options; take your dividends as cash or reinvest them. While taking the dividends as a cash payout may be tempting, reinvesting them is the smarter option. Here’s why. Let’s say you buy ten shares in a company that pays out a 10% dividend. If you reinvest that dividend, you will have 11 shares that can earn future dividends instead of ten. You can then reinvest those future dividends to end up with even more shares and continue ad infinitum. Can you see now why the compounding principle is so powerful?

Let’s examine this a bit deeper. Imagine two investors start with the same principal sum and invest in the same stocks. Investor A takes their dividends as cash while Investor B reinvests them. Investor B will end up much better off down the line because they will make a profit on their dividends as well as their initial investment. Not only that, but the longer both investors keep their money invested, the better off Investor B will end up relative to investor A. This is because their extra profits will continue to compound on themselves and generate further profits.

Reinvesting dividends in this manner can result in your investments being twice as profitable in the long run, as this report shows. Such is the nature of compounding.

Similarly, this compounding principle also works for paying off debt that accrues interest, such as a credit card balance. If you only ever make the minimum payment each month, you will pay a lot more interest in the long run. This is because the interest rate keeps being reapplied to your outstanding balance, meaning the interest compounds on itself and works against you. So, the quicker you pay off your credit card, the less interest you are charged, and the less you pay overall.

Pro-tip: The best (i.e. cheapest) way to pay off a credit card is to have a spare, unused card. You can then take advantage of the interest-free balance transfer offer that most companies provide. By transferring your balance in this way, you can pay it off at a 0% interest rate and negate the compound interest that is working against you. The small charge you pay for the transfer will cost you far less than if you continued to pay off the original balance with interest.

Compounding as a business model

The compounding principle isn’t just limited to investing, it applies in all kinds of realms. Chaos Theory, a complex branch of mathematics, can be simply summed up as small changes at the start of a process that compound into massive changes down the line, a concept also known as the butterfly effect.

Let’s look at a different example of how scaling changes things quickly.

Subscription models have become extremely popular for businesses in recent years (hello Netflix), and with good reason. Take computer games. You used to have to buy them on a CD or a cartridge that typically costs $50. Now you can download a game with no upfront cost and pay a rolling subscription for it instead. Let’s assume that a game subscription costs $5 per month.

If someone plays the game for a year, they pay $60 for it, which is slightly more than the $50 they would have paid under the old model. If they continue to play the game (paying the monthly subscription) for more than a year, it becomes significantly more expensive than buying it with a single upfront cost, as per the old model. Yet, they only ever pay $5 each month, which seems an insignificant amount, so many people never do the math and figure this out.

Even if they do figure it out, if they want to keep playing the game, they are locked in and must continue to make the monthly payments. The game company is printing money with the subscription model compared to the old CD or cartridge days because those small monthly payments compound into bigger profits over time*.

This compounding and scaling-based subscription model opens up opportunities for freelancers and individuals too. Imagine you could build a following of 1,000 people online who would pay $50 for something from you once a year. Most people couldn’t reach those numbers overnight, but they are not unrealistic to achieve over a couple of years with some hard work. If you’re able to get to that position, a quick bit of maths tells you that you would be making $50,000 revenue per year. Subtract your costs from this, and you have a nice bit of side-income, maybe even enough to quit your job and go full-time with your new gig.

Compounding for personal growth

The effects of compounding apply to more than money. Even tiny gains made repeatedly can result in significant benefits over time. In his book Atomic Habits, James Clear describes small habits as being the “compound interest of self-improvement.” Think of something you would like to be better at. Now imagine improving at it by just 1%. That may not seem like a big deal in itself, but if you got 1% better every day, you would be 37 times better in a year.

This is how the compounding principle tricks us. An individual change may seem small to the point of insignificance, so we ignore it. But if you repeatedly stack small gains on top of one another — be that financial decisions, working on a project, or practicing a skill — you will eventually end up in a much better position without ever feeling you had to make a particularly special effort.

There are no magic bullets

It can be tempting to look for the big win or magic bullet that gives you a huge, instant payoff. The problem is, magic bullets tend to only happen in the movies. Back in the real world, you are better off playing the long game by compounding small decisions, changes, and wins, then doubling down on them. Then doubling down on them again. And again. Then keep going.

*When you factor in the cost savings that game companies make by no longer having to manufacture and distribute CDs, their profit margins are even higher with a subscription model. Add that to the increased sales revenue, and it’s a no brainer for them. Include extra sales from people who would never pay £50 for a game but will try it for £5, then end up sticking around and paying the subscription fee for a few months. The game manufacturer (along with other companies using a similar business model) is killing it.


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