A week ago I spoke on how money works to a few friends. I was basically sharing what I had learnt at the feet of Warren Buffett, Charlie Munger and several other gurus about Compound Interest, Capital Allocation and the the importance of time in investing etc. Here is a thought from that talk: Simple Interest vs Compound Interest.

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Simple Interest, as we learnt in high school = Principle X Time X Rate. So every year the Simple interest remains the same because Principle, Time and Rate remain the same.

Compound Interest is like a daisy chain of many Simple Interests. In Compound Interest the Interest that accrues at the end of a year gets added to the following year’s Principle. So unlike Simple Interest, in Compound Interest the Principle keeps swelling with each passing year and so the Interest that accrues also swells. The bigger interest gets added to the following year’s Principle swelling it further and so on. It’s like a positive feedback loop.

So if you want to be wildly successful, find Compound Interest and once you find it don’t ever get off that train.

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Simple Interest and Compound Interest aren’t only in finance but touch other aspects of life and business.

For example- See’s Candies, one of Buffett’s favorite companies has an extraordinary Return on Capital. But the management of See’s Candies just can’t find ways to reinvest into the business, like Simple interest and thus has to send the profits to Buffett to redeploy elsewhere.

From See’s Candies in the West Coast of USA lets switch to the humble auto rickshaw driver in India. Here is another example of Simple Interest. Let’s say he invested Rs 2 Lakhs in purchasing the auto, fuel, insurance etc. And if he earns a profit of Rs 20,000 per month, his Return on Capital is an insane 10% per month or 120% per year! But unfortunately he can’t reinvest those profits. Same goes for the roadside vendor.

Like the auto driver’s profits the same goes for the auto driver’s skills. Like Simple Interest that also remains stagnant. So he is no way a better auto driver next year based on what he has learned this year. So he operates in a world of Simple Interest.

On the other hand, think of a software engineer. With each passing year, her skills improve and she looks back and says : I can now do in a hour what I struggled to do in a week. That is Compound Interest at work: slow at first, super fast with the passage of time. Her improved skills mean that she is now more valuable to society and therefore her salaries skyrocket. So unlike the auto driver, she operates in a world of Compound Interest.

Buffett owns a company called Flight Safety where they train airline pilots. But this business needs investments to grow because it needs more equipment or replace outdated ones. So this business operates in Compound Interest where it reinvests the profits to grow bigger and bigger.

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There are a special kind of businesses that have the best of both Simple and Compound Interest. They earn a high Rate of Return on Capital but like Simple Interest are forced to pay out big dividends to shareholders. Yet they can grow without needing Capital and get better and bigger over time like Compound Interest. Classifieds, exchanges, Asset Management Companies are some examples.

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Think back at your own life. When you were three or four you learnt alphabets. You probably took 6 months to learn them. Then when you were 5 years old you probably learnt to make small words and after that bigger words. You took long to read a small book. Now, many years later, you read many books in short time. So as you got more proficient, you did more in less time which in turn made you more proficient…like the positive feedback loop of Compound Interest.

Compound Interest in magical. Once you see it, you can’t unsee it. It’s everywhere in nature, life, business and investing.

Cheers!