If you read any book about building wealth, you are almost guaranteed to come across the idea of compound interest as the ultimate force multiplier of building fortunes. You’re almost always guaranteed to encounter the below quote as well:
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Einstein
However, it’s also almost guaranteed to skip a crucial element of compound interest that could accelerate the process and save you your most valuable commodity, time. This is what we’ll discuss here.
The favorite story used to illustrate this idea is the fictional story of the inventor of Chess and the King. In short, the story goes like this:
Long ago, when the newly invented game of chess was presented to the king, he was so delighted with it that he offered the inventor any reward he desired. The inventor said that he simply wanted a single grain of rice on the first square, two grains on the second, four on the third and so forth, to be doubled every day until the 64th square is reached. Thinking that this was a cute request, the king happily obliged. A week later, the inventor went before the king and asked why he had not received his reward. The king, outraged that the treasurer had disobeyed him, immediately summoned him and demanded to know why the inventor had not been paid. The treasurer explained that the sum could not be paid – by the time you got even halfway through the chessboard, the amount of grain required was more than the entire kingdom possessed.
There are a few nuggets that we can excavate from this simple story. The first nugget is simply the staggering potential of compounding. The second nugget is it’s elusiveness. This potential is often missed in plain sight by people. As Einstein said, “he who understands it, earns it. He who doesn’t, pays it.” Turns out that most of us pay it.
The third nugget is the easiest to miss, partly because the story actually ends before it gets to this bit, and partly because our brains don’t like to compute things in the long-term. It is this:
All of the action happens in the back end of the chess board.
Relatively speaking, the true force of compounding does not come to light until it has gained significant momentum. For the first half of the chess board, the numbers are big, but understandable. But in the back half of the chess board, they get so big that it becomes difficult to even visualize the amount of rice owed. By the 64th square, there are over 18 quintillion grains of rice on the board in total.
Of course, daily doubling is an extreme case of compounding. A more realistic example of compounding would be an investment portfolio with compounding returns at 5-7% per annum over decades.
In graph form, the typical exponential growth would look something like this:
Although the rate of compounding differs, the principles from the story of the king and the inventor hold. All of the action still happens toward the back of the graph, which can be broken into two general parts. The first is the ‘long tail’ where even with the force of compounding, the results are relatively benign. It occupies most of the time horizon on the graph, with minimal contribution to the little to the growth component. The second part is the body of ‘the beast’, where the real ‘exponential growth’ takes place.
The exponential curve represents the omnipresent Pareto 80/20 breakdown.
Conventional financial wisdom says that you should start as early as you can, and continuously invest a part of your savings into a mix of bonds and stocks that produce a consistent yield. If done correctly, this should and can work. But there is a slight problem – the long tail is, well, very long. So long that it can occupy most of your life. Decades, maybe.
The solution? Cut off the tail of the beast. Start the race at the back half of the chess board by bringing your own sack of rice. Imagine the inventor bringing 21,474,836 grains of rice, placing it on square 32 and asking the king to start doubling from there. That’s cutting off the tail of the beast.
Compounding works like a tidal wave. It starts off like as a small wave way out in the ocean. Then the momentum builds and builds until it becomes a pure monstrosity of water, sand and energy by the time it hits the shore. Instead of paddling way out in the ocean trying to catch the tail of the beast, cut the tail and meet the beast at the shore. You start the game with a lump sum of capital substantial enough to ‘skip’ the majority of the long tail.
But like most things, this is easier said than done. The beast will not easily allow his tail to be cut. For an average person, amassing enough capital to do this can only be done through implementing two principles that are almost as powerful as compounding – namely, scale and leverage. Impossible? No. Difficult? Maybe. But if you don’t figure out how cut it, you have no choice but to spend the majority of your life riding the beast’s tail. More on these two ideas next week.
Oh, btw — I missed out one part of the story of the king and the inventor. The king orders the inventor to be killed for being cheeky. Sorry, not sorry.
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