Most people don´t understand the power of compound effect. Those who claim to understand it have some common delusions about it. I belong two a group somewhere in between these groups of people. No matter who you are, understanding the compounding effect is important. Avoiding common delusions is important, too. Three most common delusions that I have confronted are:
- The average speed of compounding delusion
- Exponential growth can last forever delusion
- 1 percent each day delusion
The average speed of compounding delusion
When people talk about compounding, they usually think that parameters like the growth of investment returns, growth rates of economies, growth of infected diseases, and other social contagions compound with an average speed. Nature is more consistent with the averages. Social parameters don´t change according to the average growth rate of the compounding effect in the short run. In the long run, differences between the average growth rate and annual differences between the annual growth rate and annual growth rate in the shorter run stabilize. In the long run, we are all dead. Personal parameters and their shorter annual speeds of growth are more important for most people. Let's think about shorter time frames.
Even many professional investors or so-called ”experts” claim that annual real investment returns in stock indices will be about seven percent. What they often forget to say is that this annual compounding rate depends on the prices you pay. Assuming this seven percent without understanding how expensive stocks are right now, you are most often about to get worse annual returns. The reason for this is that most often stocks are a little bit more expensive they should be. Economic models usually expect that economies grow with more or less the same speed all the time. Economies have their cycles in which the speed of growth varies all the time. In some years growth is fast and sometimes it is even negative. Most models the direction right in most years, but the problem is that the usefulness of being right is destroyed when these models are wrong.
Social contagions have the most variation in compounding speed. What happens is that most social contagions first have a slow speed of compounding. When these contagions reach their critical mass of ”infected” people, the compounding rate starts climbing fast. It accelerates for a while until the compounding rate starts to decline. At some point, the rate can become negative. Many one-hit wonders in business, music, and writing become forgotten after their short success periods. The biggest perils usually come after experiencing these accelerating compounding rates. Egos can grow too much without understanding these things.
Compounding lasts forever delusion
I have to quote Kenneth Boulding about this delusion: ”Anyone who believes exponential growth can go forever in a finite world is either a madman or economist.” The biggest reason for this is that humans can´t overcome the fact that everything on this planet depends on energy. The processing of energy has inescapable and destructive effects on this planet. What this means is that the more energy we process the bigger the disastrous consequences like extreme natural phenomenons like storms this processing will create. Economists don´t understand these physical limits of growth. They expect everything to last forever. Humans have been great in creating new, disruptive technologies, but the world is in the point where compounding rates have to accelerate a bit all the time for a long time unless this happens, and it won´t be possible. Some or most societies will eventually collapse. I have no idea when this will happen. I am not sure if anyone has an answer to this question.
1 percent each day delusion
”Get 1 percent better each day and you will end up with results that are nearly 37 times better after one year” This quote is from James Clear´s book Atomic Habits. I like the book, but getting one percent better each day delusion is becoming more popular all the time. It is complete bullshit. Just think about it independently for a few seconds and you realize this growth rate is not even close to reality. Can you run 37 times faster or write 37 times better after a year of improving 1 percent each day? No, you won´t. Do you get better after trying to improve one percent each day? Yes, you will. If you start practicing from zero, you can probably become 1 percent better after one day. After you have practiced for a month, your compounding rate is not even close to 1 percent a day. In the first days, the improvements are probably the biggest. After a while, your compounding rate diminishes, until you reach a point where you won´t get better at all. When this happens, you have to practice for a while before getting better. After this practice, your improvement accelerates for a moment until it starts diminishing again. This cycle ends at some point and your decline will start. This happens to everyone, no matter what they do.
I have decided to start publishing texts only once in two weeks for a while. I have a diminished motivation to write. This will probably last until my summer break.
-TT
No comments:
Post a Comment