Rule #6: Let compounding do its work

Wealth

Jan 16

Compounding refers to the mathematical phenomenon by which something growing at a constant rate becomes first bigger, and then unfathomably large.

To illustrate, imagine you acquire a (magical) chicken that has two chicks a month, each of which then has two chicks of its own during the subsequent month, and so on. You begin with a single bird, and 30 days later, you have three. The next month, you have nine, and the month after that 27. By the end of your fourth month you have a slightly overwhelming 81 chickens, and by the end of the year, there are 177,147 chickens in your yard — and you likely need a bigger yard. Should this continue, you’d have tens of billions of chickens by the end of your second year (along with a profound real-world understanding of the power of compounding).

On the other hand, if you began your journey by eating two of your three chickens on Day 31, and continued this behavior every time you got two new chickens, you’d be forever the owner of a single chicken.

This example, while fowl-based and goofy, is easily ported to our discussion of money. Whenever we achieve a financial gain, should we choose to leave that gain to compound, we make it part of the new base from which future growth takes place. On the other had, should we choose to remove that gain for immediate use, it is removed from the compounding engine, in turn reducing the base from which future growth occurs.

As we’re aiming to maximize our passive income, eventually replacing our active income and thereby achieving freedom from employment, we are best served to allow our wealth to accumulate through compounding, uninterrupted and ongoing — whether measured chickens or dollars.