The math of compound interest can be hard to understand. So let’s watch a video of a fire instead. Pay attention to these timestamps…
- The start…a small fire starts next to a couch, perhaps from a cigarette in a waste basket.
- 1 minute in…the waste basket and side of the couch are on fire. A well-directed extinguisher would end it.
- 2 minutes in…the room is full of smoke and the fire is certainly bigger, but 80% of the room remains unlicked by flame.
- 3 minutes in…the entire room is fully engulfed in an out-of-control inferno.
The fire grows slowly, slowly…and then so quickly it’s entirely out of control. That’s exponential growth.
The challenging realization is that “out of control” never occurs without the first few minutes of “slowly, slowly, slowly…” Every inferno starts with a single, small spark.
The same happens with viral growth, as we know from the history of pandemics. Disease doesn’t feel scary at 10 new cases per day. But if new cases increase by 20% per day…
I don’t need to walk you through the math of compounding virality. The important idea is that the latter crazy days of mass infection are only possible after the early slow days have paved the way. Every pandemic starts with its first 1-to-1 infection.
Investment portfolios operate on the same principle. But instead of burning your house down or making the world sick, portfolio growth is a good thing.
We’ve all heard stories like…“The market was up 7% last year, and my portfolio went up $300,000! That’s compound interest in action!”
They don’t tell you when that anecdote occurs. It’s during the latter “inferno” stage of investing. It happens after you’ve diligently saved, invested, and stayed the course for 40+ years. If a $4 million portfolio grows 7%, that’s $280,000 of growth. But you need that $4 million portfolio first, which isn’t built overnight.
The same 7% increase on a $10,000 portfolio equals only $700. Just a small spark. Fast forward 10 years of consistent saving and a 7% increase on $140,000 is $10,000 of growth. Not bad. The fire is growing but still feels small. But if you keep going…
The latter years of wild success can never occur without the quiet early years of relative boredom. That’s why long-term investing is hard! The first 10 years are boring! The next 10 years aren’t much better! Only after 3 or 4 decades do you hit the point where a good year of growth outpaces multiple years of new contributions.
That’s why Charlie Munger famously says:
The first rule of compound interest: don’t interrupt it unnecessarily.
The best time to extinguish a fire is at the start. Stop the compound spread as early as possible and prevent an inferno.
Investing is the opposite. Interrupt your compounding as little as possible. Let your “inferno” grow and grow and grow.
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