“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it.”

-Albert Einstein

The power of compounding is the closest thing to magic in the realm of finance. Even if its effects don’t seem like much at first, the continuous rise and feedback loop eventually provide amazing outcomes. It is so great that human beings are terrible at predicting its effects.

One of the best time investments you can ever make is to understand this mental model and look for opportunities to use it.

The Power of Compounding Explained

Gaining returns on both your initial investment and the compound interest you receive from it is known as compounding. Here is one instance:

Every year, you invest $100 and earn 1%.

You have $101 at the end of the first year (1% of $100 = $1). You will therefore have $102.10 at the end of the second year (1% of $101 = $1.10). And onwards.

The advantages initially seem insignificant. However, they soon mount up. Ten years later, it is $110.46. In a century, it is $270.48.

This effect can be amplified by including higher returns, faster return windows, and more contributions.

For example, investing $10 a month for 100 years would equate to $12,100 but you’d actually have $20,728.25.

And that’s still using our small 1% yearly interest rate.

Compounding, however, is not limited to personal finances.

The value of compounding outside of finance

English playwright, John Heywood’s saying that “Rome wasn’t built in a day, but they were laying bricks every hour”, is a reminder of the fact that it requires time and patience to create something big and great.

Being able to understand the concept of compounding and applying it in other areas of our lives will help us achieve tremendous outcomes.

Below are some ways that can have compounding effects in our personal lives.

Learning

We add new information to our previous knowledge when we acquire new knowledge. We can expand on what we already know if we make links with other concepts.

Health

We are capable of more when we exercise more. Take a peek at the Couch to 5k programmes, for instance.

Habits

Certain habits have cumulative advantages. Similar to writing every day, the impacts may be subtle at first but become significant over time.

Publishing ideas

A single article has little impact, two might, but fifty or more, and then you have a library, which is far more valuable.

Relationships

Every time you spend time with someone, you learn a little bit more about them. And with time, the connection and bond you might have with that person gets stronger.

Reaping the benefits of compounding

Start Early or Soon

The key to reaping the benefits of compounding is to get started. The effects are tiny until they gain from past interest. The sooner you start, the sooner the effect kicks in.

What could you start tomorrow?

Start small

You don’t need a large initial investment to begin compounding.

Although it helps, most habits make that impossible. Starting is the first step towards ensuring that the effect is initiated. We can raise our inputs and take advantage of compounding once it is ” running”.

What small step could you take to move forward?

Remain Consistent

Time is the key to compounding.

Do you recall the Munger quotation from earlier? That is the main focus. Author Morgan Housel demonstrates in The Psychology of Money that investing during recessions would yield higher returns than taking money out and reinvesting it at the right periods.

That is compounding’s power.

So persevere through the difficult moments and stay focused.

In Summary

The Compounding effect is one of the most incredible forces in the world.

But not many of us really use it.

Its advantages in finance are a common topic of discussion, but we don’t have to stop there. One of the best uses of our time is to look for ways to take advantage of compounding in both our personal and professional life.

Use the compounding effect to your advantage for great long-term gains in learning, relationships, or new behaviours.