Compounding - Mental model series - 14
"Play iterated games. All the returns in life, whether in wealth, relationships, or knowledge, come from compound interest. "-Naval Ravikant
"Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. "— Albert Einstein
Compounding is when your interest earns interest.
It is a mathematical representation of positive feedback.
It is the growth on your previous growth.
Compounding plays out over the long term. In the short term, the incremental gains can be hard to notice.Also compounding applies to so much more than just your investments and credit cards.
Imagine a small, 3 inch snowball rolling across the snow. The small snowball picks up snow slowly (interest) with each roll. The snowball grows to 2x, 3x, 4x… The newly collected snow (interest) allows the snowball to pick up even more snow as it moves across the snow.
Now, imagine this snowball is your knowledge of a particular subject or your relationship with a close friend or your blog’s audience. Make small investments in these areas and watch your growth compound.
Consider James Altucher's 1 percent rule -
Improve a little each day. It compounds. When 1% compounds every day, it doubles every 72 days, not every 100 days. Compounding tiny excellence is what creates big excellence.
Charlie Munger has spoken about this effect many a times -
“I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.” - Charlie Munger USC Law Commencement Speech, May 2007
But a word of caution - one must be very careful on what are you compounding on ,
If you focus on wrong thing , compounding can be very expensive.
Then how to apply this mental model ?
Answer : Your compound base - Identify carefully
- What do you want to compound?
"I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … [I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it. - Jeff Bezo
- Is it compoundable?- Make sure this is something compoundable and useful in the long run.
- Make sure your it has solid base - Don't bet on sand castles.For example -Expiring information is not knowledge. It won’t be relevant in a month or a year.Focus on accumulating knowledge that will be as useful ten years from now as it is today.Remember First principles ?
- How does it compound ? by time or in turn? Business compounds when a transaction happens, and your bank account only compounds with time.
Warren Buffet explains why stock market out performs bonds by attributing to compound interest -
"It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, “Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.”
Footnote -
What are Mental Models ?
“It’s your mind’s toolbox for making decisions. The more tools you have, the more equipped you are to make good decisions. “
A mental model is an explanation of how something works. It is a concept, framework, or worldview that you carry around in your mind to help you interpret the world and understand the relationship between things. Mental models are deeply held beliefs about how the world works.
For More , read Mental Models - Introduction
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