UNDERESTIMATING THE POWER OF COMPOUNDING

Bill Gates famously said: “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.”

Gates’s pithy quote touches on an important shortcoming many of us face, either knowingly or unknowingly: our brains are not very good at accounting for the effects of compounding and exponential growth.

Take, for example, the classic tale of a con man who presented the king with an offer. The con man made chessboards, and knew the king loved chess. He devised a plan to trick the king into handing over a large fortune. The con man said that for his beautifully crafted chessboard he was not interested in money or jewels. Rather, all he wanted was a little rice.

“All I want,” said the con man, “is for you to place a single grain of rice on the first square, two grains of rice on the second, four on the third, eight on the fourth, and so on and so forth, for the entire 64 squares”. The king thought that for such a high-end chessboard this was a small price to pay. He agreed to the con man’s terms.

So a single grain of rice was placed on the first square, two on the second, until there were 128 grains of rice in the first row. However, the second row started to present problems for the king – by the 21st square the king owed over a million grains of rice. By the 41st square, the king owed over a trillion grains of rice. The effects of compounding had taken over, and the king obviously hadn’t factored this in.

There are countless examples of problems that involve compound growth that fool our brains (e.g., you only need to fold a piece of paper in half 45 times to produce a stack of paper tall enough to reach the moon). Our brains just aren’t wired to grasp the power of compounding.

This has important implications in the realm of investing, and the effects of compounding can present challenges, particularly when valuing high growth companies.

Source:

https://rogermontgomery.com/underestimating-the-power-of-compounding/