Mental Models: Compounding

I have been building a list of mental models to help myself better understand the world. I will occasionally do a write-up to explain one of them and how it applies to the real world. If you want to view my full list of mental models or read my previous posts on mental models then you can go to this link: https://www.mikegorlon.com/mental-models.

Compounding is a process where the value of something increases at an increasing rate over time.

Warren Buffett best described the definition of compounding in finance when he explained that compounding interest is interest earned on interest.

When you invest $100 at a 1% interest rate you will earn $1 in interest during the first year. When you reinvest that $1 you earned in interest you will then have $101 at the beginning of year 2. You will then earn a 1% interest rate on $101 in year 2.

The first year you received $1 in interest but in year 2 you received $1.01. So you are not only earning interest on your original sum, but you are earning interest on your interest.

Do this not with $100 but with millions and you will quickly see the power of compound interest.

The opposite of compounding is linear growth.

Example of linear is: 2 + 2 + 2 + 2 + 2 = 10

Example of Compounding is 2*2*2*2*2 = 32 (Can also be expressed as ²⁵)

Here is an example in the real world:

A sage once convinced the king to give him “just” one grain of rice on the first square of a chessboard, two grains on the second square, four grains on the third square, eights grains on the fourth square, and continue this doubling pattern all the way up until he gets to the last square, which is the 64th one. The king didn’t understand the power of compounding, but eventually realized that after just a couple of squares of compounding there wouldn’t be close to enough rice left over for anyone else.