“Compound interest is the eighth wonder of the world”.
I'm sure most of you have seen or heard the quote commonly attributed to Albert Einstein and grasp what it means. To illustrate it in a simplified way, I will use what is commonly known as The Rule of 72 to illustrate compounding. The Rule of 72 states that if you divide 72 by your investment return, you get the number of years in which your money will double. For instance, if your real return is 7.2%, your money will double in real terms in 72/7.2 years, being 10 years. It will then double again in another 10 years and so on. At a 7.2% real return, R100 will be R200 in 10 years, R400 in 20 years, R800 in 30 years and R1 600 in 40 years. It illustrates clearly that the longer you consistently beat inflation, the greater your eventual outcome, not just linearly but exponentially.
Three ideas follow from this example:
- Get in early to benefit from the time invested
- Stay invested for as long as possible
- There is a massive opportunity cost to spending money
The first two are self-evident, but the third isn’t commonly considered. The opportunity cost of money not invested implies that under my previous example, buying a R250k car now is the equivalent of buying a R1m car in 20 years or a R2m car in 30 years. The choice of spending money now deprives me from having something better in the future. We should obviously not completely deprive ourselves of enjoying the things we can spend our money on, but the benefit of postponing some gratification may well be worth it. Consistently making the right choices when spending, will have exponential implications for wealth in the long-run.
Consistency and compounding also extend to other areas of life, although not always as powerfully as in investment. Although consistency in other areas would compound benefits in a more linear fashion, the benefit of doing something small on a regular basis can have what one would consider outsized benefits.
Let us consider a simple “diet”. One cappuccino generally contains 120 calories. If I would cut out one cappuccino per day for 365 days and replace it with a black coffee (virtually zero calories), I would save 43 800 calories per year. This translates into 4.9kg (a gram of fat contains 9 calories) of weight loss if I previously had a diet which kept my weight constant. Consistently making one small decision thus makes a massive change if sustained over a year. Incidentally the same benefit could be had from a 2km daily walk (for someone weighing 82kg), possibly with a lot of other benefits.
The main message is that small things could have big benefits if done correctly over a sustained period. In investing it could be consistently eliminating behavioural biases, in business consistently applying integrity and fairness to clients, in health consistently exercising and in relationships consistently investing time. In all areas, the consistency in what one does is what brings material difference to the outcomes achieved.