Munger's mental models #5: Compounding!

Mental models

In this short series of blogs and videos, in honour of the late, great Charles Munger, I take a look at some of his most powerful mental models.

The power of compounding

It's been written here and all over the internet that the most powerful force in investing is compound growth. 

Nothing you haven't heard before, of course, I'm sure!

A concept from the field of mathematics, the power of compounding holds that it is possible to grow your wealth exponentially over time if you continue to achieve consistently solid annual percentage returns.

The Snowball

When Alice Schroeder wrote her biography of Warren Buffett she chose the title The Snowball, partly to reflect the ever-gathering size of Buffett's wealth and accumulated knowledge.

It's a handy analogy - when you start out the gains might appear to be modest, but over time they can get better and better as the snowball gathers pace and size as it rolls down the hill.

The phases of your investment journey

In the first phase of your investment journey, it's vitally important to spend less than you earn to get together a pool of capital to invest and start the snowball rolling.

In the second phase, as the snowball gathers a bit of momentum, you can keep adding your savings and reinvesting your investment gains.

Eventually, you will reach 'escape velocity' or the third phase of your investment journey, where the snowball reaches such a size, speed, and critical mass where you can simply keep reinvesting your gains, and over time the portfolio growth will take on a life of its own.

Get the snowball rolling

Munger once said that you need to do whatever you can to get the snowball rolling (paraphrased: e.g. by sleeping on couches, working overtime, or taking a second job) to get the first $100,000 invested. 

Only then can you ease up a little. 

Both Munger and Warren Buffett used compounding to such a lethal effect that Buffett's net worth has snowballed from around US$3 billion at the traditional retirement age of 65 to nearer US$150 billion today.

It's a phenomenal achievement, reflecting the combined power of leverage, compound growth, and time.

Of course, because the Berkshire Hathaway snowball is so large and powerful today, there's plenty more to come as well!

I discussed this a little further in the short video below:

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