Use the Magic of Compounding to Boost Your Early Retirement
Einstein is supposed to have said that compound interest is the most powerful force in the universe. I did not really appreciate it until I saw the results myself. It takes patience, but compounding can be a powerful force to reach retirement early.
Compounding: Simple, yet Powerful
My Financial Independence (FI) journey took a long time, and over that period, I learned many important lessons. One of those was the incredible power of compounding. I knew how compounding worked in theory. But knowing something and then seeing it in action are two different things.
Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.
Charlie Munger
The Magic of Compounding
There is an old fable that illustrates the power of compounding. In ancient India, there was a king who was a big chess enthusiast. One day he challenged a wise sage. The sage was a skilled chess player and easily defeated the king. The king was impressed and offered the sage any reward that he wanted.
The sage asked for grains of rice in the following manner: a single grain of rice on the first chess square, two grains of rice for the second square, four for the third, and so on….. basically doubling the number of grains of rice for the each of the next squares.
The king thought it was a small request and promptly asked his minister to give the required rice to the sage. After a few days, the king was surprised that the request was not yet fulfilled.
The minister then explained the math behind the request. If you start adding all the grains of rice that the sage had requested: 1 + 2 + 4 + 8 + 16 + 32 + ……. once you get to the last square of the chessboard, you will need 18,446,744,073,709,551,615 grains of rice.
That is eighteen quintillion four hundred forty-six quadrillion, seven hundred forty-four trillion, seventy-three billion, seven hundred nine million, five hundred fifty-one thousand, six hundred and fifteen!
How Much Rice is that Really?
To put it in perspective, if you can account for every grain of rice ever produced, you would still not be able to get to the number above. Even with the current global production levels, it would require about 2,000 years to fulfill the sage’s request.
This illustrates the power of compounding — how very small numbers 1,2,4,8,… can quickly compound to truly large numbers.
Compounding and Downturns
The above story illustrates the power of compounding when things are growing. And that definitely aided me in my quest to retire early. However, one of the things I did not appreciate early on was how compounding over time mitigates the effect of a downturn.
The longer my portfolio grew, the better I was able to deal with a downturn. This may seem obvious, but it was instructive to see this play out in an actual downturn.
In March 2020, there was a sharp decline in stocks caused by the global pandemic. The market went down more than 30% in a matter of days.
Here is where compounding was beneficial. I had built up a portfolio over the years, and hence was in a much better position to withstand this drop. The drop — big as it was — looked like this:
Despite being down more than 30% in 2020, the portfolio was still up more than 100% since the start of the decade. And the chart above does not include dividends. The gains were even more because the dividends had been reinvested.
I was able to hold on through the drop because I had allowed compounding to work its magic over the prior years.
Patience — The Key Ingredient for Magic
While compounding is magical, it takes time to work its magic. The reason I was able to successfully navigate the 2020 downturn without panicking / selling was I had given compounding many years before that to work its magic. Initially the grains of rice 1 + 2 + 4 + 16 + 32 … do not seem large enough.
As you can see below, the line barely seems to move for the first several squares. The magic of compounding is happening all along, but the effect is really felt towards the end. Only when you get to the later chessboard squares, the awesome power of compounding is revealed.
Not Giving Up
When I started my FI journey, the initial investments I made were rather small. They seemed even smaller when compared to the actual amount of money I would need to retire. At that time, it would have been very easy to throw up my hands and declare that this was an impossible task. Luckily, I persisted.
The other thing that was depressing was to see how little the investment growth was. Initially, the investment portfolio grew by very little (if at all). Watching it grow was like watching paint dry. Thankfully there was no major recession / correction back then, so at least the portfolio was growing (albeit at a painfully slow rate).
No matter how small the initial amounts or how slow the initial growth, it is important to persist through the initial time period. That is especially pertinent in this age of instant gratification.
In Conclusion
Compounding worked wonders on my FI journey. However, for compounding to work, patience is needed. It took me a lot of patience and many years to appreciate the power of compounding.
Give enough time for compounding to work its magic and it will supercharge your path to early retirement!
All human power is a compound of time and patience.
Honore De Balzac
Originally published at https://mrfiner.com on March 24, 2021.
