This is how your money grows: compounding, doubling times and the rule of 70 (Part 1)
Chapter 4 (Part 1) of "Getting a Better Class of Enemy", my investment book
I'm writing an investment book called "Getting a Better Class of Enemy - Money, Markets and Manias". As I write the chapters, they will be made available to paid subscribers to OfWealth. Previous chapters, along with the Preface and Chapter Plan, can be found by clicking on this link.
This latest chapter covers the crucial concepts of compounding and doubling times. No investor can really hope to be successful if they don't grasp the fundamental basics of these concepts. Even if you already know about compounding, I believe it's likely that you'll find some useful additional insights in what follows, especially in the section on doubling times (Part 2).
I've kept the maths to a minimum. But, as with so much in the world of finance, some number crunching is unavoidable.
This is the first part of the chapter. I’ve split it because it’s too long for some email systems. Part 2 will be emailed to paid subscribers, and can also be found at this link, along with all the other chapters so far.
As always, feedback from readers is encouraged.
Please send emails to ofwealth@substack.com
Chapter 4 (Part 1):
This is how your money grows: compounding, doubling times and the rule of 70
"The greatest shortcoming of the human race is our inability to understand the exponential function."
Dr. Albert Bartlett (1923-2013), Professor of Physics at the University of Colorado
It's time to tackle a fundamental concept of investing that not enough people fully comprehend. Before we dive into the nitty gritty of how to invest, and why some types of investments tend to work out far better than others, it's essential to have a decent grasp of how profit compounding works.
In fact, either to make a lot of money from investing, or simply to stay wealthy over time, it's absolutely crucial to know about what I'll cover in this section of the book.
To get into it, we'll start with a thought experiment. Picture in your mind's eye a huge sports stadium, one of the modern amphitheatres of athletic action. Say, Wembley football (soccer) stadium in London.
In the case of Wembley, there are seats for 90,000 sports fans. A walk around it is a kilometre long. In terms of the volume of the structure's inner bowl, if it was sealed, it could contain seven billion pints of milk.
Imagine that you are seated way up in the top row of such a place, far from the field of play. You notice someone walk into the middle of the pitch and place a single drop of water there. After waiting a minute, they place two more drops. A minute after that, they put four drops. This continues, with the number of drops of water spilled on the turf doubling every minute.
Ask yourself this: if the stadium was sealed from leaking, how long could you remain in your seat before you would be under water? What's your best guess?
Would that time be measured in hours? Or days? Or weeks?
In fact, it would be a mere 47 minutes. That's half a football game, with two minutes of extra time added. If you hadn't brought breathing apparatus, your last chance to escape would be just after the 46th minute, when the stadium would be 88% full of water.
That seems extraordinary. But how the situation would progress through its stages is pretty amazing as well.
At first, the situation would appear to change very slowly. After 39 minutes, 99% of the stadium would still be dry. It would still be 89% empty after 43 minutes. But just four minutes later, being 47 minutes since the first drop touched the grass, the whole stadium would be swamped, and the surrounding area would be drenched with overflow.
This is an extreme example of exponential growth in action. In this case, it's of an initially tiny delivery of water - just one drop - that doubles in size every minute.
This concept of exponential growth is fundamental to anyone's investment strategy, with the aim of growing your wealth over time. Although the growth rates are slower and the timescales run to many years or decades. But if you can grasp the importance of exponential growth then you'll be a much better investor.
In fact, exponential growth has major implications in all sorts of areas of our lives. But it's mostly ignored, or only vaguely understood at best.