I recently read an article in Havard Business Review on Linear thinking in a Nonlinear world. From the article it is clear how we believe things are always linear but in reality it is non-linear. We as humans suffer from bias in terms of linearity, our brain can’t understand asymmetry easily.
Let’s link linearity to compounding and then to investing.
An example of compounding:
You have $100,000 you invest it somewhere, where you can compound it at 9% per annum for longer periods of time. Naively speaking your money should double every 8 years (72 rule). Now lets consider various cases with your time horizon.
Investment horizon Your capital Incremental value added every 8 years
8 years $200,000 $100,000
16 years $400,000 $ 200,000
24 years $800,000 $ 400,000
32 years $1,600,000 $ 800,000
As we can see from the above example if you miss the last 8 years you miss an enormous 8x return. Most people don’t understand this simple concept due to our linear thinking process. Frankly speaking even I didn’t. Obviously there are other biases working when we think of investing like our ability to see short-term.
Even most of our habits and businesses compound by taking small baby steps everyday.
Albert Einstein recognised it quite early by considering compounding as the 8th wonder of the world. Warren Buffett understood it quite early in his life.
Asymmetry in business
Most businesses become great businesses if seen in terms of price within 2 years. However, such approach is highly flawed as the baby steps begin way before. Holy grail of investing is to find such businesses early in their life.
Lessons with money
Don’t be happy if you earn a lot of cash each year. Happiness should increase by multifold if you even invest this cash at high rates of return for long period of times. Don’t be happy if you spend money on unnecessary things as in the long run you would be doing a disservice to yourself by not thinking about opportunity cost of capital.