“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Albert Einstein

The Wise Man and the King

Long ago, in a kingdom where the king was known for his wisdom but also his vanity, a simple inventor came to the court with a new game – chess. The king, intrigued by the novel game, was delighted after learning it. In his generosity, he asked the inventor to name his reward.

The wise man, with a twinkle in his eye, said, “Oh, King, my request is simple. Give me one grain of rice for the first square on the chessboard, two for the second, four for the third, and so on, doubling the amount on each subsequent square until we’ve covered all 64 squares.”

The king, amused by what seemed like a modest request, laughed and agreed. He thought it would be a paltry amount compared to the treasures in his storehouses. He ordered his treasurer to calculate the reward and prepare the rice.

The treasurer, a man of numbers, began the count:

  • Day 1: 1 grain. “Easy,” he thought.
  • Day 2: 2 grains.
  • Day 3: 4 grains.
  • Day 4: 8 grains.
  • Day 5: 16 grains.

By the tenth square, the treasurer was already dealing with over a thousand grains but still thought it manageable. However, as he progressed, the numbers grew alarmingly:

  • Square 20: Over a million grains.
  • Square 30: Over a billion grains.

By the time he reached the fortieth square, he realized they would need more rice than all the granaries in the kingdom could hold. By the fiftieth square, the amount would surpass all the rice in the world.

The treasurer returned to the king, his face pale, “My lord, even if we had all the rice in the known world, we could not fulfill this reward by the sixty-fourth square.”

The king, now understanding the magnitude of this exponential growth, realized he had underestimated the wise man’s request. He learned a lesson in humility and the deceptive power of numbers. He granted the wise man land instead, for there wasn’t enough rice in his kingdom to honor the original request.

The moral of the story:

Exponential Growth: Small beginnings can lead to monumental outcomes when each step compounds over time, much like years turning small investments into vast fortunes.

The Power of Doubling: Starting with just one grain, the act of doubling illustrates how quickly quantities can escalate beyond our initial perceptions, reaching astronomical proportions.

Misunderstanding Scale: The deceptive nature of exponential growth’s initial slow pace often leads to underestimations, highlighting how we can misjudge the true impact or scale of growth until it’s overwhelming.

“Don’t be proud of your salary. Be proud of your investments.”
Warren Buffett

The Three Engines of Compounding

  1. Starting Capital
  2. Time Frame
  3. Rate of Return

The ‘Holy Grail’ of compounding would be to have high starting capital, a long time frame, and a high rate of return.

There is an interplay between the three engines of compounding. Here are some examples:

  1. Low Capital,
    • A Long Time Frame,
    • Average Rate of Return
    • This combination can still provide a satisfactory result due to the power of compounding over time.
  2. High Starting Capital,
    • Shorter Time Frame,
    • High Rate of Return
    • This mix can yield significant returns quickly, leveraging the larger initial investment to capitalize on higher returns.

“The first rule of compounding: Never interrupt it unnecessarily.”
Charlie Munger

Compounding Killers

  1. Selling: Disrupts compounding by triggering immediate costs and sacrificing future gains. I believe macroeconomic events (recessions, inflation, wars, pandemics, rising rates, etc.) aren’t the real threat to compounding; rather, it’s how investors react to them. Thus, steering clear of premature asset sales, unless strategically wise, is crucial. In short, investor behavior derails compounding.
  2. Poor Management: A significant challenge to effective compounding arises when management fails to grasp key strategic areas, potentially harming the company’s value. Here are some critical aspects:
    • Capital Allocation: Effective capital allocation hinges on a robust reinvestment engine, retaining and redeploying earnings at high returns, guided by ROCE (Return on Capital Employed)—a vital measure of capital efficiency. Reinvesting rather than paying dividends seeks to maximize returns while minimizing shareholder tax burdens. Poorly timed buybacks can erode value, underscoring the need for strategic repurchasing—buying shares below intrinsic value without borrowing to fund them—to boost shareholder wealth
    • Culture: Wall Street’s obsession with short-term gains can foster a poor organizational culture that sacrifices long-term value for quick wins. This environment often lacks the integrity, intelligence, and energy essential for sustainable growth. When misaligned with long-term shareholders, it prioritizes fleeting profits over enduring value, weakening compounding potential. A culture rooted in ethical practices and strategic foresight better nurtures an environment where compounding thrives..
    • Shrinking Moat: A weakening moat exposes a business to competition, eroding profits and growth. Companies must actively reinforce their unique strengths to sustain compounding potential. An expanding moat is equally critical—vital for deterring entrants, maintaining dominance, and shielding against threats—ensuring long-term profitability and growth.
  3. Inflation: Acts as a silent thief of compounded returns. If the rate of return on investments does not outpace inflation, the real value of money saved or invested erodes over time. This can undermine compounding’s benefits unless assets grow at or above inflation rates.

“Money makes money. And the money that money makes, makes money.”
Benjamin Franklin