When we think of seriously life-changing stuff, many of us would probably point to the existence of gravity. Gravity is one of those phenomenons that – once we understood its existence, completely changed the way we life forms do business.
But, I would argue that there’s another equally powerful force that has probably changed all of our lives whether we realize it or not.
What’s that force? It’s compounding. Not just compounding interest, but the concept of compound in general. It could be one of the most fundamental and amazing forces in nature that has a profound effect on every single one of our lives. I’ve experienced it. You, too, have experienced it.
Many of us, though, probably don’t realize its happening. But, it’s there.
What is compounding?
Compounding is the notion (or in investment terms, an actual mathematical formula) that things build on one another, and each step we take originates from a different starting point than the one before it.
For example, let’s use simple numbers to illustrate the point using something that most of us have at least heard of: compound interest.
We have $1,000 to invest in a stock account that grows by 10% every year. The first year, we invest our $1,000 and we get $100 growth for a total of $1,100 because:
$1000 * .10 = $100
Great. Now, what if I asked you to come up with the total after five years of growth rather than a single year?
If you didn’t understand compound interest, you might devise a simple calculation that looks something like this:
$1000 * .50 = $500
It seems simple enough. If the money grows by 10% every year, then it’ll grow 50% every five years. An extra $500 bucks, right?
Compounding completely changes the formula each and every year, and it means that we’re generating more of a return than a simple 50% calculation.
First year: $1,000 * .10 = $1,100 total (1000 + 100)
Second year: $1,100 * .10 = $1,210 total (1100 + 110)
Third year: $1,210 * .10 = $1,331 total (1210 + 121)
Fourth year: $1,331 * .10 = $1,464.10 total (1331 + 133.10)
Fifth year: $1,464.10 + .10 = $1,610.51 total (1464.10 + 146.41)
The total after five years is $1,610.51, not $1,500. The magic happens when our new baseline changes year after year. We aren’t starting with $1,000 in year number two. We perform our 10% calculation on $1,100 instead because that’s the amount we had after the first year. And, each year is governed by this same beautiful compounding magic.
Compounding works because our starting point changes as time goes on. You’re reinvesting your earnings, and that causes our numbers to build on top of themselves. It’s not linear, it’s exponential.
We tend to think about compounding in terms of interest. Granted, it’s an important magical element that can transform our investments into a huge pile of cash, provided you give it enough time to build (and compound). But, the magic doesn’t stop there. Compounding is everywhere.
The compounding effect in our lives
Darren Hardy, author of the insanely popular book “The Compound Effect” (affiliate link), describes compounding as such: “It’s the principle of reaping huge rewards from a series of small, smart choices. Success is earned in the moment to moment decisions that in themselves make no visible difference whatsoever, but the accumulated compounding effect is profound.”
Compounding isn’t always a positive force. In fact, some of the smallest decisions that we make in our lives that may seem inconsequential at the time can easily add up into something extremely dangerous.
My previous life serves as a primary example of how the decisions I made turned into habits, and those habits began to compound. For example, remember that time I burned through a half year’s salary right out of college to buy a Corvette? Yeah, I’m talking about this kind of shit.
Had I left it at the car I bought, it may not have turned into such a money pit. But, the Corvette I sold many years later was a far cry from the car I bought the year I graduated college. Buying the car fueled some fire within me to drive the fastest and loudest car on the road. Thus, I upgraded the hell out of that sucker. A new cat back (exhaust system) here, headers there. A supercharger went on a few years after. Race camshaft. High performance clutch. New racing tires and chrome wheels.
Each purchase individually didn’t seem like much, but in the end, I sunk more into the car in upgrades than I did to buy that son of a bitch. Those purchases compounded into blowing tens of thousands of dollars under my very nose, and I refused to let myself admit that to myself.
I sold the Corvette in 2014 for $7,000. Gotta pay to play I guess.
Let’s look at a few other examples
I started getting up 10 minutes earlier – It didn’t seem like 10 minutes a day would result in such a huge increase in productivity, but over a seven-day week, we’re talking more than an hour of compounded time that I used as productive time in the morning before I left for work (or in the case of early retirement, before I check in with social media or blog stuff).
I cut out my evening desserts – Okay, it was only a single chocolate chip cookie. But even a conservative estimate of 60 calories a pop results in a reduction of 420 calories in the week. But over a year, that’s 21,840 calories!
I keep my inbox clear (near #InboxZero) – I get a slew of email, but proactively keeping my inbox clear has had a profound compounding effect on my productivity. Emails are much easier to find. Every time I look at my email, I’m not hunting and pecking for what needs my attention. I’m also not taking the time to verbally (or mentally) complain about how cluttered my inbox is every other day. Over time, this adds up to an incredible boost in email productivity. I no longer think about email clutter.
I have started saying no – The number of times I’ve said no to things over the course of the year has saved me hours upon hours of frustrated time spent doing things that I have no particular interest or business getting involved with. Naturally, I have a problem saying no. When someone asks me for help, my instinctual answer is always yes. I want to help. But, sometimes I just can’t. I may not have the time. Or the knowledge. Or, quite frankly, the interest. When I agree to help with something that I have no interest in, it feels like a chore. And, that’s not what early retirement is all about, now is it?
I no longer throw register impulse items into my cart – You know all that cheap shit at grocery stores around the registers? You’re waiting in line and begin to look around to pass the time. You’ll notice that pack of gum. Or bottle of soda. Or that elk jerky (yes, I’ve seen elk jerky at registers before!). You might be tempted to throw one of those items into your cart. It’s only a few extra bucks. But, you’ll probably do it again. And again. Each time you add an impulse item to your cart, it becomes easier to rationalize the next time. And the next. And, the extra few bucks each time adds up, and fast.
The examples are nearly limitless. Compounding takes the smallest decisions we make in our lives and magnifies them under a microscope for closer inspection. What do those decisions look like when the results are observed over a number of days, months and years? Are they pretty?
Compounding shows you.
What say you? Can you identify any smaller decisions you’ve made in your life that, over time, added up into significant benefits?
Steve is a 38-year-old early retiree who writes about the intersection of happiness and financial independence. Steve is a regular contributor to MarketWatch, CNBC, and The Ladders. He lives full-time in his 30′ Airstream Classic and travels the country with his wife Courtney and two rescued dogs.