This really is an incredibly powerful model that delivers exponential impact through consistent marginal gains rather than a sudden change.
Compounding is the process of ‘paying interest on interest’ which results in exponential growth. More broadly, it is the exponential growth that arises through small, consistent, and accumulated progress.
A principal investment which pays consistent interest will provide consistent linear returns. By contrast, Compounding pays on the principal plus interest. With the base sum incrementally increasing, the new interest calculation increases at an exponential rate.
Called ‘the miracle of compounding’ and claimed to be referred to as ‘the eighth wonder of the world’ by Albert Einstein, this financially inspired mental model can be applied to a range of domains.
In other contexts, it might be better recognised as the ‘Snowball Effect’, inspired by a snowball rolling down a hill and exponentially gathering size. Perhaps a difference in the terms relates to the implied momentum behind the snowball effect.
THE ART OF MARGINAL GAINS.
Compounding and the Snowball Effect highlight the power of sustained marginal gains in health, learning and developing relationships. In a business context, it can be used to challenge notions of disruptive innovation with an alternative approach that taps into the power of consistent and marginal improvement.
Check the In Practice section below to view the 'rice and chessboard' example for a striking demonstration of compounding.
IN YOUR LATTICEWORK.
This model works well with the Habit Loop and Systems vs Goals, in terms of establishing a daily routine for greater impact. It also relates closely to the Domino Effect, where initial actions can create flow and momentum; as well as Critical Mass, in terms of reaching a key point of accelerated change.
- Look for long term compound interest opportunities.
Avoid simple interest when there are compound interest opportunities available. Commit to them for the long term to maximise the exponential nature of their returns.
- Prioritise consistent marginal improvements.
Whether it relates to fitness, work or eating habits, consider the impact of committing to a 1% improvement every day. Such a commitment will compound, creating exponential improvement if maintained over time. You will tend to undervalue such incremental and consistent improvements, yet it remains a powerful option.
- Look for snowball effect opportunities.
Consider which actions have the potential to gather their own momentum and grow exponentially. This might include building up knowledge consistently, improving fitness or making improvements to processes.
The rice and the chessboard.
This famous mathematical problem often takes the form of a mythical story that describes a king of India who was a chess enthusiast. The king challenged a traveling sage to a game, offering to reward the sage if he won. To the king’s surprise the sage requested rice as a prize.
Specifically, if he won, the sage requested that the king put a single grain of rice on the first chess square and then double it on every subsequent square. The king accepted and soon lost the game and the wager.
The calculation of the payment began with one piece of rice on the first square, two on the next, then four, then eight and so on. However, based on exponential growth, by the end of the board, the king owed over eighteen quintillion pieces of rice — about 2,000 times the annual world production. The story tells that the now very wealthy sage was paid in instalments over the rest of his life.
1% better mandate at GE.
As the CEO of GE, Jeffrey Immelt ran a ‘1% Better’ mandate. This focus led to identifying micro-improvements in efficiency. He argued that by consistently applying this 1% increase GE would boost productivity in the US and, over a period of 20 years, could raise the national income of the company by 30%.
Not so much a limitation of the model, more a reminder that, in an investment context, compounding can be used for negative or positive impact. Interest is obviously beneficial to the investor or creditor but unfavourable for borrowers. Most large loans use simple interest formulas while credit cards tend to use compound interest and present a dangerous option.
More broadly, Carl Sagan pointed out the limits of compounding in relation to bacteria growth. He explained that although such bacteria experienced exponential growth, that “exponential growth never can go on very long in a finite space with finite resources.”
Compounding is a powerful and often underestimated effect that relates to any form of consistent growth.
Use the following examples of connected and complementary models to weave compounding into your broader latticework of mental models. Alternatively, discover your own connections by exploring the category list above.
- Butterfly effect: the amplified effect of small factors in chaotic systems.
- Chain reaction: in terms of an initial action gaining momentum and causing ongoing impacts.
- Activation energy: the energy required to begin.
- Systems vs goals and habit formation: the ability to improve over time with consistent activity.
- Munger’s latticework of models: the slow and steady growth of mental models and the connections between them.
- Opportunity cost: considering losses over time rather than as an initial calculation.
- Critical mass: as an alternative view to gradual growth.
This mental model is also known as interest on interest or the snowball effect.
Compounding is an ancient concept, with the use of compounding on debt condemned in ancient civilisations such as Rome. Richard Witt’s 1613 book Arithmetical Questions is cited as the first deep explanation of compounding, though it had been covered in other texts more briefly before that.
Use this online compound interest calculator to find out how much money you can get from initial investment considering multiple factors like contributions and interest rates.
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