Compounding
Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pay it.
Hello and welcome to another issue of my newsletter. Today we talk about a concept know not only in finance but in almost all aspects of life; Compounding.
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Compound interest is the addition of interest to the principal sum of a loan or a deposit.
In other words, interest on interest.
Like a snowball, it starts small and slowly; as it goes down the lane, it gains momentum and becomes larger. So, the earlier the interest starts to gain interest, the larger your interest can be and the faster it can grow over time provided you don’t interrupt the momentum.
As Albert Einstein said, Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pay it.
Compound interest doesn’t only apply to finance or money; it also applies to our habits and other endeavors like building a relationship or a youtube channel, or a newsletter or even a Twitter following. It doesn’t have to be called compounding interest, it can also be called the flywheel effect.
Like a flywheel, you start to rotate it with force, and then slowly it takes off, once it gains enough momentum, it continues to run on its own.
When building anything your actions acts like interest, you either adding little by little or chipping away what either direction you already going.
Most daily activities result in tiny results, you hardly make life-altering decisions. They are usually far in between. However, these little actions we take create ripples, and bit by bit their impact becomes more visible.
This concept is simple and looks obvious however, the reason it is hard to implement is that we do not see the immediate results. The results usually lag our actions so it is easier to skip and switch to short-term thinking and short-term actions with immediate results. However, if we stick with it long enough we begin to see the result little by little and then it suddenly starts to all make sense.
Compounding or the flywheel effect does not operate linearly. An example of a compounding effect is the Fibonacci sequence.
It starts from 0 and 1 then adds the last two previous numbers. It continues in that pattern
0,1,1,2,3,5,8,13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584 ……
When starting, it looks slow at the beginning, up until the fifth term it increases linearly by 1
0+1 =1, 1+1=2, 2+1=3 after the fifth term it increases faster in an exponential pattern.
Fibonacci isn’t the only foud in numbers, it is found in nature too.
So, yeah, that's how compounding works. Starts slow then increases rapidly and becomes self-sustaining.
You can play with numbers to see how compounding works with a compound interest calculator.
That wraps it up for this week and see you next Sunday.