Edited extract from the book Don’t Stress, Just Invest (Allen & Unwin) by investment podcasters Alec Renehan and Bryce Leske.
If you find it difficult to get your head around investing, that’s okay. You’re not alone. Investing is the process of putting money away today with the expectation of having more in the future. And the future is uncertain.
Unfortunately, our brains weren’t made for this, and time and time again have shown themselves to be pretty poor long-term financial decision-makers. All of our evolutionary biology, our impulses and our instincts have evolved over millions of years to help us survive day-to-day, not to plan for decades to come.
Unsurprisingly then, our brains struggle to comprehend exponential growth – one of the most amazing features of investing.
We generally think linearly (everyone can add 6 + 6 + 6) but struggle to think exponentially (fewer people can multiply 6 × 6 × 6).
But exponential growth is all around us.
What is exponential growth?
Population growth is perhaps the clearest example. Think about your family tree: as each successive generation has multiple children the number of branches grows exponentially. That, on a global scale, is why it took 123 years for the world to go from 1 to 2 billion people and just 11 years to go from 7 to 8 billion.
In 2020, the world got a crash course on exponential growth. As Covid-19 started to spread around the world, reports were that the number of cases were doubling every three to four days. We all became armchair virologists and came across the R number, which measures how quickly infection spreads through a population. An R score of 1 means that each infected person infects one other person (that’s linear growth). In the early days of the pandemic, we were seeing R scores of between 2 and 3, meaning each infected person infected two or three more people (that’s exponential growth).
Even the smartest people in the world struggle with exponential growth. In 2004, Bill Gates was astounded that Gmail offered 2 gigabytes of free storage. He couldn’t possibly see how users would need that much. Gmail now gives away 15 gigabytes as standard. Computing performance has grown exponentially and the cost of computer storage has fallen exponentially. Yet even Bill Gates, who had a front row seat to the computing revolution, couldn’t cast his mind forward and think how these trends would continue into the future.
How compounding works in investing
When it comes to finance, the exponential growth of our money is driven by one of the most powerful forces in the world: compounding. Compounding is when the money you make on an investment also starts earning money, which over time leads to an exponential growth in your wealth.
In the first year of an investment, you’ll earn money. In the second year, you’ll earn money on the money you originally invested and on the money you earned in the first year. On and on it goes, as every year the money you made in previous years is also earning money.
Think back to the linear growth (6 + 6 + 6) and exponential growth (6 × 6 × 6). If we save a consistent amount every year, we will see our wealth grow in a linear fashion. If we invest that money, we will see our wealth grow exponentially.
But because our brains struggle to grasp exponential growth, we struggle to see just how different that could be.
If our money was to grow linearly, then the amount of money we made each year would be the same. Each year we’re saving $1,200 under the mattress or in the savings account that pays next to zero interest. In the case of exponential growth, our money is growing by a consistent amount each year (in this case 8%—the long-term average for the share market). But it isn’t just the money we originally invested. It is all the money that we’ve made in previous years that is growing alongside our original investment.
This is the power of compounding in the share market and it’s the reason why you’ll often hear people say ‘you need to invest for the long term’.
Over the long term, average returns can compound into above- average wealth.
Purchase Don’t Stress, Just Invest by Alec Renehan and Bryce Leske at Booktopia and Dymocks.
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