The Miracle of Compounding

As I mentioned last week, people just don’t learn about personal finance from established institutions. Elite universities and bulge bracket employers do effectively nothing to counteract the financial ignorance with which today’s youngsters graduate high school.

I was lucky. My dad taught me very early on about the miracle of compounding. The way he did it stuck with me, and has served me well ever since.

When I was about 6, it was time for me to have an allowance. What 6-year-old doesn’t want some foldin’ money to buy whatever his 6-year-old heart desires? Bad news – an allowance was not in the cards. That’s not how my dad rolled.

Interest Payments

I wanted my parents to give me money. My dad patiently explained that under his allowance program, I would give him money instead. And you wonder why I ended up on Wall Street?

There was a silver lining, though. After I gave my dad five dollars, every day he would put a quarter on my nightstand. He called them “interest payments.” I kid you not, he actually called them interest payments.

The really brilliant two-fer here was that he was going to work early every morning, so the interest payment doubled as a reminder that he was around and cared, even if I didn’t see him as much as I wanted to in the early days.

Epiphany

A little ways into of this unwittingly-usurious program I had going, I realized something. The result: “Hey Dad, can I give you another five dollars?”

I’m sure it would have taken me longer if it wasn’t 1,800% annualized interest. But eventually I got it. I kept lending to him more and more. He remembers tapping out at 75 cents per day, I remember it being more than that, but regardless, the lesson had been learned (on both sides).

My dad taught a 6-year-old about the magic of compound interest experientially. This wasn’t because I was unusually gifted. At that age I was more concerned with things like waiting for it to rain so I could gather up a bunch of worms and put them all over my sister’s bedroom.

I literally did that, and (to furnish further evidence that I had excellent parents) my mom told me if I didn’t remove them all, I would have to sleep in there. But I digress…

My dad was able to teach me that valuable financial lesson because, like any American 6-year-old, I was self-interested. As soon as I saw what a great deal this was for me, I wanted to double down. With that deal, it only took 20 days to get my principal back. Then it could be invested to earn even more. When the money I had made started to make money of its own, that’s when the light bulb went on.

Not Another Article About Compound Interest

If there’s one poster-child concept for what it means to learn about personal finance, it’s compound interest. But as we’ve seen just now, that concept is easy for a 6-year-old to grok if you give him the right experience.

The real value in this concept comes when we take the concept of compound interest and abstract out the principle of compounding itself.

The principle at work here is ultimately the value of capital, and capital takes many forms.

Skills

Imagine what would happen if you took whatever skill you use at work and improved it by 1% every day. For those who are familiar with self-help literature, it will seem trite to read this. But there’s something miraculous about this compounding.

If you calculate it arithmetically, then you end the year a full 3.65 times better than you were before. If you welcome in the way this works geometrically (allowing yourself to “earn interest” on the interest you’ve already earned), this is boosted to 36.78 times better than you were before.

Let’s leave aside for the moment the seeming ridiculousness of getting that much better at any skill you bring to bear in the workplace. In some contexts, it’s possible, but for many that will seem absurd.

But, that’s actually good news in at least one respect. If your goal is to be twice as good as you are now, then it takes way less than 1% improvement every day to get you there in practically no time at all. Realistically, you can even back it down to “get a little bit better every day” and still be amazed at what comes out on the other side.

Time

We’ve now covered how compounding applies to money, and how it applies to skills. There’s an important third angle to cover here, and if you know anything about what I’m up to with ChroniFI you won’t be surprised to hear what it is: time.

There’s a part of this that is obvious to anyone who sits and thinks about it for a moment, and a part of it that’s not so obvious.

The obvious part of compounding with respect to time is that you can invest the proceeds of your work time now to earn more free time in the future. No, you can’t invest an hour itself and have it produce a minute every day for the rest of your life in a direct sense. But you can exchange your time for money now, let your money grow, and then swap it back for more time in the future.

Notice how in the previous paragraph we needed to exchange our time for money to start leveraging the power of compounding. The non-obvious part of time compounding comes when we exchange our time for something other than money.

Not All Side-Hustles Are Created Equal

Let’s say you have a full-time job and are thinking about accelerating your pace toward Financial Independence. I’ll leave aside my commentary about why accelerating might not always be the right choice, because you’ve heard that before.

You’re thinking about taking on a side-hustle. Let’s say you’re an excellent writer, and you’re thinking about writing snappy little blog posts when you have time after work. If you want, you can hire yourself out as a freelancer. The buyer of your time picks the topic, you bash out an article for them, and you invest the proceeds in an index fund. Compounding mission accomplished.

There’s another route to letting this time compound for you, though. Instead of selling the product of your labor, you can retain its ownership for yourself. In this case, that blog post becomes a part of your nascent blog, your portfolio, and more generally speaking – your assets. It’s something that can continue to pay dividends in terms of revenue, authority, ranking, or whatever your preferred currency is down the line.

Here's an example of what I mean. I have a good friend for whom bashing out a couple blog posts a week for $500 each would have not-so-long-ago seemed like a dream come true. An extra $52k/year for a few hours of work per week doing something she loves and is exceptionally good at? Sounds like a dream scenario.

But she didn’t sell her time, and that turned out to be a marvelously good thing. She wrote for herself. And the result makes that $52k/year look laughable. And on top of that, she had full control over her topics and schedule. Not too shabby.

That’s Not All

It’s not hard to see how this same principle can operate in other realms. If you’re a software developer, build an app for yourself. If you’re a woodworker, invest the proceeds from selling your first pieces into buying good machinery that will amplify the quality and impact of your future labor.

Even if you have a skill that doesn’t lend itself to practicing on your own, negotiate with your employer to get more of your pay in equity. This can be especially appealing with startups, where you have the dual tailwinds of cash-strapped founders and a higher correlation between your effort and the success of the enterprise.

The point is simple. If you find a way to take ownership of the result of your labor, you can effectively invest your time instead of just spending your time to earn money.

The Moral of the Story

You can leverage compounding in terms of money, and that concept is easy enough for a six-year-old to understand. This is a key ingredient to any sound financial plan for the future.

But you can also leverage compounding with respect to your skills, and even small daily incremental changes in your skill level can wind up improving your abilities by leaps and bounds, so long as you sustain that upward trajectory through time.

Finally, you can leverage compounding through your time. You can sell your free time, invest the proceeds, and reap a harvest of more free time in the future. But an often-missed aspect of this time-compounding is the fact that money is not the only asset that can earn a return.

We’re so used to thinking about returns in terms of money that sometimes we forget that it is a placeholder and scorecard whose role is to evaluate and purchase other assets. If you want, you can cut out the middle man and transform your time into assets that will continue to generate returns (through money or another medium).

As an added bonus, if you store up the results of your efforts in a form other than money, you’re not at risk of spending them in a moment of weakness on some kind of consumption that is not aligned with your long-term goals.

The bottom line is that small and sustained changes in the right direction are all it takes to wind up way ahead in the long run. Just as we’ve discussed elsewhere, jerking the steering wheel abruptly is often not the right path to sustained change.

Develop the right habits, and let the passage of time do the heavy lifting for you. If you get the process right, the product will take care of itself.

Ben Miller

Founder of ChroniFI

February 2022

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The foregoing are the opinions of the author and are for educational purposes only. They do not represent professional financial or investment advice. For financial advice, please consult a licensed financial professional.