Rule#44 Rule of Linear and Compounding Effect (RULICOM)

The rule

            There are two ways our income or asset value can grow. Linearly or through compounding effect (exponentially). Linear growth means our income or asset value increase by roughly a fixed value every year. Compounding growth means our income or asset value increase by a percentage portion every year. An easy way to determine whether your income or asset value increase linearly or through compounding effect is by plotting the value for each year on a graph and look at the shape. If the shape looks more like a straight line, then that means your income or asset value grows only linearly every year. If the shape looks exponentially or something like a line that shoot upwards after some time, then that means your income or asset value increase through compounding effect every year. Although having a linear growth is better than not having growth at all, you should be aiming for compounding growth to increase your asset value quickly.

Sample graph showing linear growth for red line and compounding (exponential) growth for blue and green line.

What is this rule

            According to Albert Einstein, compounding effect is the eighth wonder of the world. The result produced due to compounding effect looks something like magic. This is because a small amount of money invested consistently over a period of time in an investment vehicle that produces consistently good return every year will grow exponentially into a very huge amount. I have illustrated this point before for Warren Buffet who is considered the most genius investor in the world. To recap, Warren Buffett investment company Berkshire Hathaway provided annual return rate or 22% consistently for 36 years since 1964. Therefore if in 1964 someone invested USD 10,000 in Berkshire Hathaway, then the investment in 2010 is worth a staggering USD 80 million. This is achieved thanks to the power of compounding effect. Warren Buffet is of course the end of the spectrum. For mere mortals like us, we would have done a good job if we can find an investment vehicle that produces annual return rate of between 10-15% consistently for a long period of time.

            As magical as the result of the compounding effect, you need to know that compounding effect can also work against you. A simple example to illustrate when has the compounding effect worked against you is when you take a loan. Have you ever calculated how much interest you have to pay when you took a loan? Consider when you take a personal loan of RM 120,000 for 15 years. At 5.5% interest rate, you would have to pay about RM 1217 every month. If you multiply this amount with the number of years, you will get the value of RM 219,060. This means the total interest you would have paid over the 15 years period is RM (219,060-120,000) = RM 99,060 which is about 82.55% of the principal amount. Unless you use the money from the loan in an investment vehicle that can provide return higher than 5.5%, you are actually losing money every year. This is the effect of negative compounding effect. So be careful when you take a loan. You should only take a loan to buy something that will appreciate in value such as land, house, stocks etc. Sometimes we as human being take up a loan to buy luxuries and that is up to you as an individual. The important point to take note is to minimize such loans to as low as possible to minimize the negative compounding effect from such loans.

            Another point to take note is that compounding effect not only applies to finance and investing but to other areas of life as well. For example if you exercise regularly and do some weight trainings, you might not see any immediate physical changes. However, the compounding effect of long term regular exercise and weight training will result in some serious changes to your health and muscle mass. Consider also the negative aspect of compounding effect. Instead of regular exercise and weight training, what would happen if you confined your daily routine by eating junk food and being a couch potato? Maybe you cannot see any visible result in the short term but over the longer term your health would probably deteriorate.

            You can use the concept of compounding effect in your business as well. For example if you offer your customers great service over many years, the compounding effect of their word of mouth marketing will generate a consistent and profitable stream of income. If on the other hand, you only aim for short term profit regardless of your customers’ satisfaction, you will slowly lose your customers and this will result in lower and lower profit which eventually could lead to bankruptcy.

How to implement this rule

By the time. Verily man is in loss.
(Al-Asr : 1-2) 

Here we are trying to define the mathematical term; the achievement of academics is to apply them in daily life. The wonder of compounding is to make your money work for you. Compounding is the process of generating earnings on your asset’s reinvested earnings. Compounding works on two basic premises: re-investment of earnings and time. The longer time you leave your money to compound, the higher is the wealth you generate.


“Time is the most powerful weapon in an investor’s arsenal. Nothing comes close to it.” The mantra is to start investing early in life and do not get late at all. Also it shows how powerful compound interest and regular investing is. When we invest early in our lives, the amount keeps growing and when it becomes a big chunk, the growth in amount every year is a lot more, compared to initial years.

The benefit of compounding effect will only show itself after some time. Don’t expect to double or triple your money quickly using the compounding effect. The key is to be consistent. If you invest regularly, the result might not be apparent immediately. Perhaps after 5 years you will start to see some small result. Only after 10-20 years the full gear of compounding effect will kick-in, giving you explosive growth on your investment. Don’t be greedy when investing and you need to align expectation on your investment return to a realistic figure such as the expected GDP growth.

More about this rule

Consider the story below to demonstrate the power of compounding effect.

Compounding Effect – Rice on Chessboard

A courtier presented the Persian king with a beautiful, hand-made chessboard. The king asked what he would like in return for his gift and the courtier surprised the king by asking for one grain of rice on the first square, two grains on the second, four grains on the third etc. The king readily agreed and asked for the rice to be brought. All went well at first, but the requirement for 2n - 1 grain on the nth square demanded over a million grains on the 21st square, more than a million on the 41st and there simply was not enough rice in the whole world for the final squares.

The total number of grains of rice on the first half of the chessboard is 1 + 2 + 4 + 8 + 16 + 32 + 64 + 128 + 256 + 512 + 1024 … + 2,147,483,648, for a total of exactly 232 − 1 = 4,294,967,295 grains of rice, or about 100,000 kg of rice, with the mass of one grain of rice being roughly 25 mg.

The total number of grains of rice on the second half of the chessboard is 232 + 233 + 234 … + 263, for a total of 264 − 232 grains of rice. This is about 460 billion tones, or 6 times the entire weight of the Earth Biomass. On the 64th square of the chessboard there would be exactly 263 = 9,223,372,036,854,775,808 grains of rice. In total, on the entire chessboard there would be exactly 264 − 1 = 18,446,744,073,709,551,615 grains of rice.