Relatively important goals like building wealth that would set one up for life is something that takes a lot of time and effort to achieve, even though one may have a good plan on how to achieve it.
In a traditional sense, exponential gains are the result of applying a constant growth rate to a quantity over time.
Using investing as an example, if one invests $1,000 and it grows by 10% every year, then the person will have $1,100 after one year, $1,210 after two years, $1,331 after three years, and so on.
Keep in mind that in today's world, 10% yearly return may sound about average as there are a number of investments that bring in more than 10% per year.
However, the main point is that the amount of money invested increases faster over time, because the growth rate is applied to the previous amount, not the original amount.
Depending on how we look at it, compound interest is also a form of exponential gain although it takes a relatively longer time frame to materialize. Sometimes, a decade or two.
A noticeable difference between exponential gains and compound interest is the frequency of compounding.
Exponential gains are usually calculated on an annual basis, meaning that the growth rate is applied once per year.
Compound interest, on the other hand, has a compounded frequency that can vary from monthly to quarterly or even daily. This means that the interest is added to the principal more often, and the principal grows faster.
To illustrate this difference, let's compare two scenarios.
First scenario, we invest $10,000 at an annual interest rate of 10% compounded annually for 20 years. And in the second scenario, we invest the same amount at the same rate, but compounded monthly for 20 years.
Here are the results:
| Scenario | Final Amount | Total Interest | Percent Increase |
|---|---|---|---|
| Annual | $56,044.11 | $46,044.11 | 460.44% |
| Monthly | $72,890.22 | $62,890.22 | 628.90% |
From the table, we can see that the monthly compounding scenario yields a higher final amount, total interest, and percent increase than the annual compounding scenario.
The rule is that the more frequent the compounding, the faster the growth.
When we look at the difference in growth rate however, exponential gains have a knack of coming out on top.
This is because they're usually based on the overall performance of an asset. Which means that the growth rate depends on the market conditions(which can be very good sometimes), the demand and supply, and the risk and return of an asset.
Compound interest is mostly based on the agreement between a lender and a borrower, such as a bank and a depositor. So the interest rate has a certain fixity as it depends more on the terms and conditions between associated parties than the overall performance of the market.
It will be hard to create a realistic scenario to illustrate the difference in growth rate, a lot of changes can happen within a decade or two, especially in terms of market movements.
But let's assume that the market will be relatively stable for all that while. Here is the result of investing 10,000 each in a particular stock and a bank account both of which have historically average annual return and annual interest rate of 10% for 20 years.
| Scenario | Final Amount | Total Interest | Percent Increase |
|---|---|---|---|
| Stock | $67,275.00 | $57,275.00 | 572.75% |
| Bank | $56,044.11 | $46,044.11 | 460.44% |
Surprisingly, the difference isn't that much, although it is in favour of the stock. Part of the reason is because the stock scenario reflects a higher potential return, but this also comes with a higher potential risk.
Stock price can fluctuate significantly depending on the market conditions, and there is no guarantee that the stock will perform well in the future based on past performance.
The bank scenario is the opposite, in that it has a lower potential return, but also a lower potential risk.
Exponential gains and compound interest can be combined to achieve even higher returns and build generational wealth that lasts more than a lifetime.
In practical terms, this may require taking a longer term view and working with different time horizons.
With compounding, the earlier one starts, the better. Because time is a powerful multiplier of the snowball effect.
Predicting assets that will experience an exponential gain is akin to predicting the weather. Forecasts will be made but the day always turns out to be different, even if it is slightly.
However, good discernment is a skill that can be learned. There are rhythms and patterns that can be observed and analyzed in the market, as well as indicators and signals that can be used to gauge the potential gains and associated risks of an asset.
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