The Psychology of Money
Compounding and Compounding
Summary
Our scientific knowledge of Earth is younger than you might think. Understanding how the world works often involves drilling deep below its surface, something we haven’t been able to do until fairly recently. Isaac Newton calculated the movement of the stars hundreds of years before we understood some of the basics of our planet. It was not until the 19th century that scientists agreed that Earth had, on multiple occasions, been covered in ice. There was too much evidence to argue otherwise.
All over the world sat fingerprints of a previously frozen world: huge boulders strewn in random locations; rock beds scraped down to thin layers. Evidence became clear that there had not been one ice age, but five distinct ones we could measure. The amount of energy needed to freeze the planet, melt it a new, and freeze it over yet again is staggering. : The gravitational pull of the sun and moon gently affect the Earth’s motion and tilt toward the sun. During parts of this cycle—which can last tens of thousands of years—each of the Earth’s hemispheres gets a little more, or a little less, solar radiation than they’re used to. And that is where the fun begins.
The amazing thing here is how big something can grow from a relatively small change in conditions. You start with a thin layer of snow left over from a cool summer that no one would think anything of and then, in a geological blink of an eye, the entire Earth is covered in miles-thick ice. As glaciologist Gwen Schultz put it: “It is not necessarily the amount of snow that causes ice sheets but the fact that snow, however little, lasts.” The big takeaway from ice ages is that you don’t need tremendous force to create tremendous results. If something compounds—if a little growth serves as the fuel for future growth—a small starting base can lead to results so extraordinary they seem to defy logic.
Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child. As I write this Warren Buffet's net worth is $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s. Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him. Consider a little thought experiment. Buffett began serious investing when he was 10 years old. By the time he was 30 he had a net worth of $1 million, or$9.3 million adjusted for inflation.
What if he was a more normal person, spending his teens and 20s exploring the world and finding his passion, and by age 30 his net worth was, say, $25,000? And let’s say he still went on to earn the extra ordinary annual investment returns he’s been able to generate (22%annually), but quit investing and retired at age 60 to play golf and spend time with his grand kids. What would a rough estimate of his net worth be today? Not $84.5 billion. $11.9 million.99.9% less than his actual net worth.
Effectively all of Warren Buffett’s financial success can betide to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. His skill is investing, but his secret is time. That’s how compounding works. Think of this another way. Buffett is the richest investor of all time. But he’s not actually the greatest—at least not when measured by average annual returns. Jim Simons, head of the hedge fund Renaissance Technologies, has compounded money at 66% annually since 1988. No one comes close to this record.
If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8×8×8×8×8×8×8×8×8, your head will explode (it’s 134,217,728). IBM made a 3.5-megabyte hard drive in the 1950s. By the 1960s things were moving into a few dozen megabytes. By the 1970s, IBM’s Winchester drive held 70 megabytes. Then drives got exponentially smaller in size with more storage. Atypical PC in the early 1990s held 200–500 megabytes. Things exploded.1999—Apple’s iMac comes with a 6-gigabyte hard drive.2003—120 gigs on the Power Mac.2006—250 gigs on the new iMac.2011—first 4 terabyte hard drive.2017—60 terabyte hard drives.2019—100 terabyte hard drives. Put that all together: From 1950 to 1990 we gained 296 megabytes.
From 1990 through today we gained 100 million megabytes. If you were a technology optimist in the 1950s you may have predicted that practical storage would become 1,000 times larger. Maybe 10,000 times larger, if you were swinging for the fences. Few would have said “30 million times larger within my lifetime.” But that’s what happened. The counter intuitive nature of compounding leads even the smartest of us to overlook its power.
You can’t blame people for devoting all their effort—effort in what they learn and what they do—to trying to earn the highest investment returns. It intuitively seems like the Best way to get rich. But good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.
References
The Psychology of Money-Luck_and_Risk_Summary
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