In one of my recent posts (My Super-Simple 4 Step Guide to Building Wealth) I mentioned that I would explain the law of compounding, and why it’s so friggin awesome, in a future post.
Well, the future is here!
The Law of Compounding
I hope you’re comfy and have a cup of [insert your favorite beverage here] in your hand because I have a little story for you.
Once upon a time, there was a King. Let’s call him Nevil.
King Nevil wanted to reward a peasant who had saved his daughter’s life.
“You can have anything your heart desires,” he bellowed.
The peasant asked that a single grain of rice be placed on a single square of a chessboard.
King Nevil and his courtiers burst out in hysterics at such a small request.
Once they had all finished laughing, the peasant continued and added that the number of grains must double each day and be placed on another square of the chessboard, until all the squares were filled.
The King thought this was a ridiculous request, but nevertheless, he agreed.
However, by the time they reached the 64th square, there wasn’t enough rice in the kingdom, so King Nevil had the peasant hanged. (…because that’s what everyone does when they run out of rice!)
I don’t know if that story is true, but its factual correctness is irrelevant to the point I’m trying to make. (However, I can tell you that the King’s name is most certainly not Nevil – I made that part up.)
The story demonstrates the law of compounding and helps illustrate why Einstein described it as the most powerful force in the universe and the 8th wonder of the world.
I bet you’re thinking, how did the kingdom run out of rice? That’s exactly what I thought when I read the story and, at first, I assumed that they were exaggerating to make a point. Buts let’s do the math.
A chessboard is 8 squares x 8 squares, totaling 64 squares.
The first square gets 1 grain of rice, and then it’s doubled each time.
|SQUARE||RICE ON SQUARE||TOTAL RICE ON BOARD|
18,446,744,073,709,600,000! (I’m glad I don’t have to pronounce that number.)
That’s a shed load of rice! …or should I say a kingdom load?
The law of compounding is multiplying growth on top of growth, and as you can see, the impact can be huge.
How does this help you?
Compounding is a universal law that applies to assets, investments, interest, savings, cash flow, business, branding, education, time, habits, and even knowledge!
Each time, you think you’re getting just one grain of rice, when in actual fact, you’re getting a lot more.
Let’s apply the law of compounding to some modern-day scenarios.
You have £100 and you’re going to invest into an account which gives a return of 10%. (The average rate of return for the S&P500 – the top 500 companies in the US – has been around 10% dating back to the 1920s.)
Here’s what would happen…
|Year||Return at 10%||Total Money|
|1||£ 10.00||£ 110.00|
|2||£ 11.00||£ 121.00|
|3||£ 12.10||£ 133.10|
|4||£ 13.31||£ 146.41|
|5||£ 14.64||£ 161.05|
|6||£ 16.11||£ 177.16|
|7||£ 17.72||£ 194.87|
|8||£ 19.49||£ 214.36|
|9||£ 21.44||£ 235.79|
|10||£ 23.58||£ 259.37|
|11||£ 25.94||£ 285.31|
|12||£ 28.53||£ 313.84|
|13||£ 31.38||£ 345.23|
|14||£ 34.52||£ 379.75|
|15||£ 37.97||£ 417.72|
|16||£ 41.77||£ 459.50|
|17||£ 45.95||£ 505.45|
|18||£ 50.54||£ 555.99|
|19||£ 55.60||£ 611.59|
|20||£ 61.16||£ 672.75|
|21||£ 67.27||£ 740.02|
|22||£ 74.00||£ 814.03|
|23||£ 81.40||£ 895.43|
|24||£ 89.54||£ 984.97|
|25||£ 98.50||£ 1,083.47|
|26||£ 108.35||£ 1,191.82|
|27||£ 119.18||£ 1,311.00|
|28||£ 131.10||£ 1,442.10|
|29||£ 144.21||£ 1,586.31|
|30||£ 158.63||£ 1,744.94|
It’s important to point out that no extra money was invested. You put in only £100 and you left it.
In the first year, your 10% return was only £10, but in year 30, your 10% return was £158.63, almost 60% more than your starting investment!
Why is this?
…because you are getting growth on top of growth!
People expect to get a £10 return every year, calculating a total return of only £300 for the full 30-year period. When in actual fact, your total return (minus your initial investment) was £1,644.94, an increase of over 1700%!
Not too shabby!
When most people decide to improve themselves, they try to make huge earth-shattering changes.
This strategy almost never works because it’s too much too quickly.
But how about if we focus on just improving ourselves by 1% every day? At the end of the year, we would have improved by over 3770% (if my maths serves me correctly).
As you can see, even the smallest changes to your lifestyle and daily routines can have huge effects.
Flying a plane
Okay, so I’m assuming that most people who are reading this are not pilots, but just hear me out because this is a good example.
Imagine you’re flying from LA to New York. If, when you leave LA, you point the plane just 1% off-course to the south, instead of landing in New York, you’ll touch ground in Delaware.
That tiny, almost insignificant and invisible adjustment, landed you 150-miles off target.
There is one thing that makes the law of compounding work, and that’s TIME.
The more time you have, the greater the rate of your return.
This is not a strategy for quick wins. This is a strategy for patient people who chip away slowly over time.
As you can see, these small percentages aren’t enough to make you take notice in the beginning, it’s only at the end where its multiplying effect can easily be seen.
The thing to remember about the law of compounding is that the results are rear-loaded. This means you get the maximum benefit at the end, not at the beginning. So, when it comes to investing or making positive changes, the longer you are able to do it, the better.
In this post, I’ve just touched the tip of the iceberg. If you want to learn more about the law of compounding and how you can work in your favor, then the book I would recommend to you is The Compound Effect by Darren Hardy.
You can check out my full review of the book by clicking here.
It’s a super book! Simple to read and easy to implement. I rated it 10/10.
…I may have stolen a few examples from his book for this post, but shhhh, don’t tell him. ?
Almost every successful person is leveraging this law, whether it be in building their wealth, building their bodies and mindest, or building positive habits.
You will achieve a whole lot more (and it will be a whole lot easier) once you understand the core principles of compounding.
As Einstein said, it really is the 8th Wonder of the World.
P.S. If you have any questions (or would like to point out any incorrect calculation I may have made ?) please pop them in the comments box below.