Compounding applies not only to finance and investing but to other areas of life.
For example, if you embark on a body building regime you will not see any immediate physical changes, but the ‘compounding effect’ of long term weight training will result in some serious changes to your health and muscle mass.
What about your business? If you offer your customers a great service over many months or years, the compounding effect of their word of mouth marketing will generate a consistent and more profitable stream of income.
Compounding can also work against you.
- Instead of weight training, what do you think would happen to your physique if you confined your daily activities to crisps and soap operas? Maybe no visible result in the short term, but over the longer term ill-health, a muffin top and high cholesterol – no doubt!
- And your business: Consistent crappie service will compound into lower and lower profits and inevitable bankruptcy.
The good and bad sides of compounding apply to many areas of life, and that includes money.
Remember: In finance, compound interest is interest working for you, i.e. interest on interest earnings.
But this is true only under one condition. The benefit of compounding is only realised if your investments generate positive returns almost every year over the long term.
- A $1000 investment earning 10% interest will grow to $6727 after 20 years, but only if the 10% applies each and every year. During good times, it is pretty easy to harness the power of positive compounding. Just go with the flow.
What about during the bad times or periods which offer negative returns? Do you still benefit from positive compounding – absolutely not!
- A $1000 investment which loses 50% of its value will need to work twice as hard (i.e. grow 100%) just to get back to it original value. An investment that loses 50% in the first year and 20% in the second year will have to grow 150 % in the third year to recoup its starting value.
- Negative compounding will hurt your bottom line.
- Stock markets are full of unpredictable negative price movements, which is why you will struggle to realise income freedom with the conventional buy and hold approach.
- Financial experts will highlight their ‘superior’ annual returns to make their products stand out, which unfortunately is highly misleading. Salesman do not shy away from advertising the effects of positive compounding, but when it comes to negative compounding, ‘not a peep’.
How do wealth creators avoid negative compounding?
- You must become an active manager of your business or investments. Gone are the days where you can pick a unit trust or mutual fund and sit back and relax your way to financial freedom.
- As a stock market investor, you will need to take advantage of good and bad economic cycles. This involves identifying market trends and implementing specialised risk management techniques. Not the easiest job around, especially when the vast majority of professional fund managers are unable to consistently beat the market.
- The best way to achieve income/financial freedom is to exploit people’s needs rather than financial markets. This involves building a passive income business where the objective is to generate passive income streams around basic needs using systems that do the work for you. Property and information marketing are two prime examples.
The key lesson:
Basic human needs are a lot more predictable than financial markets, which means that you can easily avoid negative compounding.
Income creation is the new wealth creation. Do you want to learn how to build two powerful income streams that enable you to live your ideal lifestyle?
Also, download my free ‘Rule of 6’ ebook which outlines the six golden rules of building wealth.