First rule of compounding: Never interrupt it unnecessarily

The First rule of compounding: Never interrupt it unnecessarily

The earth used to be covered in ice. Practically all of it. Then it melted, refroze, again and again. Five times this happened in the last few billion years.

Scientists knew about ice age cycles long before they knew why they occurred. It confounded them. Then, a century ago, a Serbian scientist named Milutin Milankovic studied the earth’s position relative to the sun, and came up with the theory we now know is accurate: Our planet wobbles just enough to change how much solar radiation is let in, occasionally by enough to wreck havoc.

A few years later a Russian meteorologist named Wladimir Koppen ran with Milankovic’s work, dug a little deeper, and discovered a fascinating nuance.

The prevailing idea before Koppen was that ice ages occur when the earth’s tilt supercharges the wrath of cold winters. K0ppen showed that wasn’t the case. Instead, moderately cool summers are the culprit.

It begins when a summer never gets warm enough to melt the previous winter’s snow. The leftover ice base makes it easier for snow to accumulate the following winter, which increases the odds of snow sticking around in the following summer, which attracts even more accumulation the following winter. Perpetual snow reflects more of the sun’s rays, which exacerbates cooling, which brings more snowfall, and on and on.

You start with a thin layer of snow left over from a cool summer that no one pays much attention to, and after a few tens of thousands of years the entire earth is covered in miles-thick ice.

It’s an example of compounding in nature. And it shows what can be built off a freakishly small base.

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More than 2,000 books are dedicated to how Warren Buffett built his fortune. Many of them are wonderful.

But few pay enough attention to the simplest fact: Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child.

$80.7 billion of Warren Buffett’s $81 billion net worth was accumulated after his 50th birthday. Seventy-eight billion of the $81 billion came after he qualified for Social Security, in his mid-60s.

That’s impressive enough. But to really understand these numbers we have to go back half a century.

Thirty is an important age, a time when ambitious workers break free from entry-level jobs and can begin saving real money. The distribution of net worths isn’t particularly stratified for those in the teens and 20s, but starts to spread around age 30. An extra $100,000 of net worth can push someone in their 20s from the 50th to the 95th percentile. By age 30, you need an extra $390,000 of net worth to make that jump.

But Buffett became serious about investing several years before puberty. By the time he was 30 he had a net worth of $1 million, or $9.3 million adjusted for inflation. The 99.99th percentile.

So, let’s do a thought experiment.

What if Buffett got serious about investing when he was age 22 – just out of college – instead of age 10? Imagine he spends his 20s learning about investments, and his net worth at age 30 was in the still-impressive 90th percentile. Using today’s net worth percentiles and adjusting them for 1960s-era inflation, that would mean he’d be worth about $24,000 at age 30.

Now we can do some fun calculations.

If, at age 30, Buffett was worth $24,000 instead of the $1 million he actually accumulated, and went on to earn the same returns, how much would he be worth today?

$1.9 billion.

That’s 97.6% lower than his actual net worth of $81 billion.

The punchline is that 97.6% of Buffett’s current success can be directly tied to the base he built in his teens and 20s. Like World War II-era stuff.

$1.9 billion is nothing sneeze at. But you’d need twice as much to make Bloomberg’s list of 500 richest people in the world. Which is to say: Without the capital base Buffett built before he could grow a beard, you’d probably never have heard of him.

So many things in business and investing work like this.

It is tempting to look at an outlier – a company, a brand, a net worth – and study the most recent things that added to its success. Like brutal winters during an ice age, or Buffett’s investments over the last decade. But to appreciate why these things grow to the size they do, we have to study the initial small bases. The bases that no one paid attention to, because they seemed so quaint.

Why did Amazon start with books? Jeff Bezos once explained:

You have to go back in time to 1994, and there’s something very unusual about the book category.There are more items in the book category than there are items in any other product category. One of the things that was obvious you could do with an online store is have a much more complete selection.

E-commerce was insanely hard in the 1990s. It was slow, and people didn’t trust it. If your pitch was “this is more convenient than going to the store,” you were toast, because it wasn’t. If, like Amazon, your pitch was “We have more stuff than your local store,” you had a real value prop. A value prop that stuck with customers during the dot-com shakeout of the early 2000s. It’s a base few paid attention to, but explains a lot of Amazon’s current success.

Most brands are like that. Brands are fueled by their consistency. Consumers value quality products, but not as much as they value the confidence of knowing exactly what they’ll be getting before they buy. This requires years of delivering a predictable experience. Apple has a strong brand, not just because it builds good products, but because it’s consistently been building good products since the 1980s. Deep roots, strong base.

Doctors prescribed 258 million doses of antibiotics in 2015. How did we get here? Army doctors panicked in the early 1940s at the thought of millions of GIs suffering from infectious disease, which, during wars, can do more damage than bullets. They sprinted to experiment with a strange mold discovered a decade earlier that annihilated bacteria in petri dishes. By D-Day, the first mass-produced doses of penicillin were ready for use. There are so many things – radar, assembly lines, jets, rockets – that owe their modern success to small groups of 1940s Army engineers who were driven by an ethos of, “We have to do this right, and we have to do it right now.” It built an unbelievable base of technology that compounded in the 20th century.

Same with behaviors. U.S. cigarette usage began spiking in the late 19-teens, and again in the early 1940s Why? Because this was during world wars, and militaries have long known that giving soldiers cigarettes is an easy way to offer the only bit of joy they may experience for years. Cigarettes were included in soldier rations. Since your parents’ propensity to smoke is one of the strongest indicators of whether you smoke, this compounded across generations after soldiers returned home, and smoking usage rose fivefold from the start of World War I through the 1960s.

The unassumingly strong base is rooted in the same thing: Compounding is not intuitive, so it’s systematically overlooked and underappreciated.

Michael Batnick once explained it. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it’s 134,217,728).

It is so easy to overlook how powerful it can be to take something small and hammer away at it, year after year, without stopping. Because it’s easy to overlook, we miss the key ingredients of what caused big things to get big. How can most of Buffett’s success be attributed to what he did as a teenager? It’s so crazy, so counterintuitive. And since it’s crazy and counterintuitive we overlook the right lessons. So we write 2,000 books on how Buffett sizes up management teams when the biggest and most practical takeaway from his success is, “Start investing when you’re in third grade.”

Physicist Albert Bartlett put it: “The greatest shortcoming of the human race is our inability to understand the exponential function.”

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Starting fresh with a clean slate can be an advantage. Unburdening yourself from past decisions is key in a world that always changes.

But there are times when you have to relentlessly leave something that looks small alone so it has a chance of compounding into something big. Charlie Munger explained: “The first rule of compounding: Never interrupt it unnecessarily.”

Start investing as young as you can. Encourage young people to do the same. Build a reputation through small, consistent acts. That’s where everything huge begins.