Thread by @flaneur_a

Compounding - the fundamental phenomenon behind every success

Compounding is said to be the 8th wonder of the world. Rightly so. It is the fundamental phenomenon behind any success in any domain - evolution, success, investing, fitness, skill development, relationships & so on.

Here is a statement that I have probably made the most on Twitter - Right from the Big Bang, which led to the advent of the universe, to the success of Facebook & Amazon, every success has undergone a compounding (every failure too has compounded at a negative growth rate!).

In plain english, the phenomenon of Compounding is that Success begets success. Every success:
1) makes a system inherently strong
2) opens new avenues, and paves way for future success

Amazon, which started as a e-store for books, built on initial success and ...

(3/n)

...expanded on reach, products, competitive strength etc.

Every time a species survived a period of crisis, it evolved into a stronger species. Even within a species, there were random mutations & every time, those with a particular trait survived, they continued the gene pool

I intend to write on how to use this fundamental phenomenon in everyday life. I also want to delve into a misconception about Compounding which the best of best seem to be having.
But first, let’s get the mathematics out of our way...

(5/n)

Formula of Compounding

A = P(1+r)^t
A - Final Outcome
P - Initial Balance
r - rate of change
t - number of iterations

This is as mathematical as this post gets. From here on it's going to be plain English.

What is Compounding - Compounding is an iterative process, where the starting base P changes with a certain rate r. With every iteration, the changes made in P gets appended back to it, before the next iteration starts.

(7/n)

Suppose P = 100, r = 5%. After the first iteration, P becomes 105. Now, in the next round of iteration, it is 105 (not 100) that grows by 5%.
In the similar vein, if r = -5%. After the first iteration, P becomes 95. Successive r% works on 95.

The Objective - With P as a starting base, the objective is to grow it over time. As you can see there are three levers to grow - P, r and t. The question is which lever is more important.

P, the starting base, is obviously important. As many investors say, to make money, you need money. It’s easier to become a billionaire, if you are already a millionaire. However, the problem is that it is not in your control most of the time. It's a given, a starting point!

r is more important than P, because it is something that you can control. Also, it is powered by t, so it carries more, well, power!
The most powerful lever is t as it forms the power in this function - the number of successful iterations. This is surely in your control.

(11/n)

Let me throw some examples…

Let’s say you want to learn swimming.
Formula:
Perfect Swimming = Current level of skill (1+(amount of practice or learning rate))^(no.of practice sessions)

It will help, if you already know the basics of swimming and do not fear water(P).

But, that is something which is (as we say in Physics) “given” in the problem.
Your amount of practice & learning rate surely matters. However, it is very difficult to put more than 1 hour in a serious practice session.

(13/n)

If you want to learn swimming quickly, the best way to do it is to practice daily, rather than only on weekends, which is better than practising once a month, which is better than practising only when you visit a resort once in 3 months!

Your current swimming skill is a given. There is a limit to how much you can learn in one session. The best way to learn swimming quickly is to practice everyday - daily compounding!

(15/n)

Netflx = -r% Books = +r%

Again occasional binge watching is fine. But, if you squander your time series after series, while your competitor/peer is spending the same time on honing her skills, or working on her project, or reading books...no prize for guessing...

...who’s emerging as a better person on the other side.

As you can see from these examples, why habits are so important. Habits are compounding iterations!

(17/n)

Investing:
Wealth = Initial Capital (1 + r)^(no. of years)
You know the drill. I"ll jump straight to the solution to create long term wealth. All you need is an Investment Process that gives you a consistent positive r. Once you have it, all you need is several iterations.

You don't have to chase a big growth rate. You don’t need a big r, all you need to ensure that r is positive. You must have read about the 1.01 vs 0.99 rule - You get 1% better vs 1% worse everyday for 1 year.

(19/n)

A small difference in r, +0.01% vs -0.01% makes so much of a difference is compounded everyday for an year. The final value of INR 1 is Rs.37.8 and Rs.0.03 in the respective cases.

(1+0.01)^365=37.8
(1-0.01)^365=0.03

I reiterate, it’s great if you have a high r, but all you need is a positive r, as long as you have enough number of iterations.

P.S. - I"ll write about the common fallacy separately & append it here later.

(21/n)

Appending the thread on the Common Fallacy...

https://twitter.com/flaneur_a/status/1283782713334353921

Concluding the thread with the closing remarks:

Compounding is not back-ended. It is the fastest & the only way to grow. Irrespective, of what your starting base (P) is, all you need is a consistent positive growth (r) and enough iterations (t)!

rationalflaneur.com/compounding-th…