WTF Are Investments? Part 3: Math Is Magic
Here’s a lesson on how investing works, not advice on how to invest.
The thing about investing is there is this thing called compounding. It’s how your money grows. Compounding is the reason why investing works.
Compounding Is A Snowball Rolling Down A Mountain
Think about your investment as a snowball at the top of the mountain. The size of the snowball represents the amount your investment is worth. The bigger the snowball, the larger the value.
The mountain is time. As the snowball rolls down the mountain, time is passing.
While your snowball is rolling down the mountain, it begins to collect more snow and it grows.
How The Snowball Grows
As your investments grow, you are able to generate money from them. This can be in the form of interest payments, something called dividend payments or the actual value of the investment — the price you could sell it for — increases.
You can earn interest and dividends and the value of investment increases. In other words, it’s possible that one, all or a combination of these things can happen to grow your investment.
Back to the snowball rolling down the mountain. As it’s collecting more snow and growing, your investment paying you in interest and/or dividends. As the snowball grows, it becomes larger. A bigger snowball is able to attract more snow because of how big it is. The surface area keeps increasing, making it possible to attract more snow and grow exponentially.
THAT’S THE MAGIC OF COMPOUNDING INTEREST.
As it rolls (as time passes) it grows and grows and grows. By the time your little snowball reaches the bottom of the mountain, it’s grown to be a giant snowball of fuck-you cash — well, that’s the hope.
The Bigger The Mountain The Better
We’ve all heard that one ought to start investing early and invest often. The underlying rationale here is if the snowball has a long way to roll down the mountain, it has a better chance of accumulating a lot of snow. And if you keep adding to the snowball, you help it grow so it can attract more snow.
All of This Was Made By Us and Anything Can Happen
The markets, the money we use, the value we assign things and the economics concepts underlying all of this theory was made by humans. We totally made all this shit up and use math to help us measure it all.
We created stocks, bonds, mortgage-backed securities, all of it. There is a lot that we don’t know and that we can’t predict. We control what we can and try to manage the risk on the things we can’t. At the end of the day, that’s what investing is.
Anything can happen — in the investment world and the real world. Maybe one day we won’t use the financial markets as a means to make money. Maybe one day, human work will disappear, robots will do all of our work and we will be living in WALL-E. But good to know all this anyhow in case nothing changes at all.