“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”…Albert Einstein
There are quite a few ways of enhancing one’s wealth significantly viz. winning a lottery, hitting a jackpot, receiving a windfall inheritance from a rich grandma or a dead Nigerian dictator. What we are going to discuss here is not nearly as exciting as any of these. It is called compounding one’s money over time, and it is actually excruciatingly boring. As boring as watching grass grow. Compounding can be achieved in different forms, however it is the only sure-shot way that doesn’t require much luck, The bad news is in spite of learning about it in our grade 8 math, most of us do not put it in practice. The good news is everybody can do it in one form or the other with some patience, discipline and smart thinking.
Many of you who are the ‘math type’ would have come across this. The distance from the earth to the moon is 384,400 KM. If I ask you to keep folding a 0.1 mm thick sheet of paper till the total thickness is enough to cover this distance, how many times do you think you need to fold? Assume the paper is of infinite length and you can actually keep folding it as many times you want. When I did the calculation myself, the ‘smallness’ of the answer totally blew my mind. This is compounding on steroids. If you are feeling too lazy to do the math yourself, stick with us…the answer will be hidden somewhere on our site.
10,000 hours of compounding
I believe compounding goes much beyond the domain of finance. The power of compounding affects our lives every day either positively or adversely. My own interpretation of the secret behind Malcolm Gladwell’s ‘10,000 hour rule’ is pure unadulterated compounding. When you practice something for a long period, you enhance your skills. When you keep practicing your enhanced skills to enhance them even further, magic happens. Unfortunately there can be no short-cuts to this.
When we regularly train in the gym, it is a similar kind of compounding. Initially it feels difficult, but as we cross the initial hurdle, the tougher work-outs get easier with every passing session. Stronger muscles after a few sessions makes more rigorous exercises seem easier and that helps build the muscles even stronger. The same principles apply to learning a musical instrument or a new language or perfecting your golf swing.
The only difference between the other domains and the domain of finance is that in most other domains the growth gets capped at one stage. Incremental benefits taper out but the practice helps maintaining the level. Lack of practice would surely have a negative compounding effect in many cases. In the domain of finance, the compounding growth is relatively uncapped (had to keep this disclaimer of “relatively” for reasons discussed in later blogs).
The simplest definition of compounding in finance is found in Investopedia: “The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings”. The equity graph is beautifully convex as compared to the equity graph where no compounding takes place (where earnings are withdrawn)
Patcharee’s Pandan Chicken
I often have this craving for spicy Thai food and the best Thai food in Singapore can be found at a place where most of my friends would probably never venture. It is also arguably Singapore’s ugliest building – The Golden Mile Complex on the Beach Road….maybe the only ugly building in Singapore. Khun Patcharee (name changed to protect identity), the 55 year owner of one of this completely nondescript eatery, served me the best Pandan chicken I ever had….and along with that she gave me an amazing lesson in compounding. She used to be a bar girl in Pattaya and her current employees (similar age group) used to be her fellow bar girls. She was quite candid and had no problems admitting that 30 years back all her current employees used to attract more ‘clients’ as they were ‘more beautiful’. I found it quite hard to believe. They all look jaded and tired now whereas Khun Patcharee looks happy, confident, smart, graceful and had an intelligent spark in her eyes. Now they all work for her. While the other girls were busy blowing their earnings on fake Louis Vuittons and Pradas, Khun Patcharee was investing it in her own tiny eatery in Chiang Rai. She would rent her fake Louis Vuittons and Pradas instead of buying them, and hence had a significantly lower cost of living compared to her colleagues. Every Baht of earnings was invested in her eatery business.
She has never heard the word “compounding” but unknowingly has been practicing it for almost 3 decades now. Her current business is an extension of her earlier eatery after she moved to Singapore. She reinvests her SGD profits to purchase her non-perishable raw materials in THB in Chiang Rai, where her younger sister lives. Her current customers (mostly Thai migrant workers in Singapore) act as free-of-cost couriers to get her the supplies when they come back from their holidays. They enjoy a discounted meal in return. The number of such free couriers have grown with the growth of her reinvested profits. She has even become the sole supplier for some of the herbs not only in Golden Mile complex but to other places as well. Imagine her margins. Her middle sister runs the same business model in Little Bangkok in Hong Kong and they now also own a back packers’ hostel in Chiang Rai. The icing on the cake is that her only daughter is going to graduate this year with an Accounting degree from one of Thailand’s top universities, Chulalongkorn University. Zero debt, very low costs, unbelievably smart cost arbitrage and relentless compounding,…why do I have to go anywhere else, be it for my Pandan chicken or for my lessons in compounding.
……To be continued