JAMES CLEAR, in his bestselling book Atomic Habits, offers this thought-provoking notion: Suppose a plane takes off from Los Angeles on its way to New York. But after taking off, the pilot turns the nose of the plane by an almost imperceptible 89 inches. Where will the plane end up? The answer: nowhere near New York. As it flies across the country, that 89-inch difference will take it hundreds of miles off course.
Clear’s purpose is to help readers appreciate a concept that’s difficult for the human brain to grasp: compounding. The idea—common in investing but also applicable to other areas of our lives—is that repeated actions build on each other to produce results that are dramatically larger than you might expect. A common and entertaining example: If you were to take a piece of paper and fold it in half and then fold it in half again, and do that 40 more times, it would grow so high that it would reach the moon. Continue folding that piece of paper just nine more times, and it would reach the sun.
Another example: Suppose you started with one penny on the first day of the month and then doubled it each day—to two cents, then four, then eight and so on. The results are similar to the paper experiment: After 10 days, you’d have $5. After 20 days, you’d have $5,000 and, after 30 days, you’d have more than $5 million.
While entertaining, these examples are so extreme that they’re of little practical value. But they carry an important lesson: The path to improvement in any domain does not require swing-for-the-fences, Herculean efforts. It requires only small steps done consistently. This is the meaning of “atomic habits.”
The problem is, we’re just not very good at doing compound calculations in our heads. We tend to think more linearly. Ask people to guess at the paper folding question, and typical answers will be in the range of three feet. Answers to the penny question normally fall in the range of $1,000. Unless you work out the math step by step, it’s very hard to make an estimate that’s anywhere close to correct.
The result—because the human brain isn’t wired to think in compound terms—is we believe we have to take dramatic steps to see any progress at all. That’s why things like the keto diet are all the rage. Why aim for a lowly goal like losing a pound a week when you could shed 50 pounds in a matter of months? Or, in the world of personal finance, that’s why it’s common to see magazine covers promising “137 Ways to Get Rich” or “8 Stocks to Buy Now.” Get-rich-quick schemes appeal to people not because they’re lazy, but because they don’t appreciate the reliable math behind a get-rich-slowly approach.
How can you apply the power of compounding to your personal finances? Here are three ideas:
1. If you’re early in your career and not saving at all, start with a small contribution to your 401(k), perhaps just 1% of your income. You’ll barely feel it and, at first, the progress will seem minimal. Indeed, it will be minimal. But don’t get discouraged. That’s the tricky thing about compounding. At first, the results will seem incredibly slow, but eventually they start to snowball—just like that penny that grows from $5 in 10 days to $5,000 in 20 days. The key is to keep going even when it feels like you’re going nowhere.
2. If you have a high income, you might not think it’s worth contributing to a Roth IRA. As you may know, high income individuals aren’t eligible to contribute directly to Roth IRAs. Instead, you have to follow a two-step process. With an annual contribution limit of just $6,000, you might feel it isn’t worth the administrative effort.
But consider this example: Suppose you’re 35 today and married. You’ll be able to contribute a combined $12,000 to Roth IRAs in 2019 and increase the annual investment modestly over time, as the contribution limit increases. If you do that every year until you’re 65 and earn 7% average returns, you would end up with more than $1.5 million. Don’t think about it as “just $6,000.” Think about it as potentially $1.5 million.
3. If you have children in college and are paying astronomical tuition bills, you might feel it isn’t worth the effort to economize, that any savings will be just a drop in the bucket. But suppose you’re 45 years old and your first child is entering college. Let’s say your kid is considering two private schools, each charging about $70,000 per year, but one offers $5,000 in aid. At first, that might seem like an insignificant difference.
But that ignores the value of compounding. If you shaved $5,000 off your tuition bill for four years and earned a 7% annual return on those savings, you’d end up with $100,000 at age 65. Yes, $5,000 might seem like a small difference in the context of the enormous bills you’re paying, but don’t think about it that way. Look at it as $100,000. Not getting offered that $5,000 in aid? Remember, private colleges are businesses—and they’re perfectly willing to negotiate aid packages.
Adam M. Grossman’s previous blogs include Apple Dunking, Intuitively Wrong, Paper Tigers and What Matters Most. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.