The Rule of Compounding: Why Small Steps Lead to Big Gains

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Growing up, long before he experienced success and became worth billions of dollars, a young Warren Buffet would tell his family and friends, “Do I really want to spend $300,000 on this haircut?” The haircut he was referring to, of course, wasn’t in the six-figure range. It probably would have cost him closer to $20. Buffet’s point was that if he cut his own hair, saved the monthly $20 expense, and invested it, over the course of his life all of those seemingly insignificant $20 investments would have netted him thousands of dollars. Buffet was speaking to the law of compounding gains, which goes something like this: small investments made consistently over time build upon themselves and, eventually, amount to something big.

“Recognizing that every dollar you spend today is $10 or $100 or $1,000 you won’t have in the future doesn’t have to make you a miser. It teaches you to acknowledge the importance of measuring trade-offs. You should always weigh the need or desire that today’s spending fulfills against what you could accomplish with that money after letting it grow for years or decades into the future. And the more often you trade, the more likely you are to disrupt compounding and to have to start all over again,” writes Jason Zweig in the Wall Street Journal. 

Compounding isn’t just useful in finance. It is a principle that applies to all of life. Brushing your teeth every day is a small investment. If you skip it, nothing bad happens on that day. But if consistently skip it, those small “not so bad days” add up—and you are left with a costly, both financially and in terms of human suffering, dental disaster.

Some other areas where compounding gains matter a lot:

In all of these examples, you build on what you did today, tomorrow. You start the next day just a little bit better, often so little you can’t even measure it, than you were the day before. But if you add up those increments over the course of a lifetime, the result can be massive.

Another important lesson related to consistency and compounding is this: It is harder to make up losses than it is to accrue gains. For simplicity’s sake, imagine that you have $1.00 and it goes down 50 percent. In order to get back to where you started, you must double your 50 cents; or put another way, you must go up by 100 percent. The same goes for so many endeavors beyond finance. If you attempt a heroic effort and it goes poorly—for example, you go for broke in sport and wind up injured; you go for broke in a relationship and wind up in way over your head; you go for broke in diet and wind up with an eating disorder—getting back to where you started is going to require a lot more effort than the potential gains that you lost.

Put simply, if you go big or go home you often end up home, and with a long journey to get back to where you started. If you go small and steady over a long period of time, however, you often end up with something big. Are there exceptions to this rule? Of course. If you are in the home stretch of an Olympic gold-medal race then taking a huge risk, one that could result in an injury, might be worth it. After all, perhaps you’ll never be in that position again, and the upside is being crowned the best in the world. But these types of exceptions prove the rule.

In the final analysis, the rule of compounding gains says that it is important to resist skipping small good habits or engaging in small bad ones. It’s not just about the benefits or losses you experience on that particular day, it’s about the compounding benefits or losses. Equally important, resist the urge to put forth heroic efforts. Generally speaking, if you fail, the work required to get back to where you started is going to be a lot more than your potential gains.

Don’t think about being consistently great. It’s a trap. It’s impossible. Think about being great at being consistent. It’s a reliable path to growth and achieving one’s potential that makes a lot more sense.

Brad

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5 comments

  • The overall tone of the article is great here – what I just don’t like is using the haircut argument without going deeper into trade-offs – which you mentioned later. What if the haircut gave us shot for a better work? What if it makes us feel more confident? What if it the choice we’re doing now gives some other form of value that compounds even more? Of course these are difficult questions :) So, I love the second part of the article, especially the being great in being consistent – which I myself struggle with sometimes, it’s just that the Buffet story is kind of “click baity” here, more than teaching. Have a great day!

  • Love the analogy of compound interest. So true that the small things add up to big gains.

  • Great article again! On a side note: why doesn’t the article have a publishing date? to make it an evergreen? and so that future readers don’t get repelled by an ‘old’ article?

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