Marshmallows, compounding and why to think long-term
To eat or not to eat the marshmallow, that is the question
You are 4 years old. Instead of taking you to the playground like any other day, your parents take you to a building you have never been to before. You are in a room with a man who gives you a marshmallow and tells you that you can either eat it now or wait for him to return, in which case he will give you a second marshmallow. You feel really tempted. You love marshmallows. You would eat the one marshmallow straight away, but if you wait you will get another one. What do you do?
Time preference (i.e. the value of getting something now vs. getting it later) applies to most decisions you make in your life; whether you choose to continue your studies or join the workforce early, exercise or watch a movie, eat healthy food or junk food, invest or spend… you name it.
The beauty of thinking long term is that it delivers better outcomes. Why? Because doing something over the long term enables you to build on it: returns build on returns, expertise builds on experience, trust builds over time. This is essentially compound interest.
The case outlined above is a real experiment conducted by Stanford Professor Walter Mischel (along with Ebbesen and Zeiss) in 1972. They were doing research on “self-control”, and in particular, wanted to test how much distracting activities would help delay gratification. Serendipity added an interesting twist to this experiment, and in follow-up studies, the researchers found that the kids that managed to wait longer for the second reward tended to do better in life, as measured by SAT scores, educational attainment, body mass index, etc.
Each one of us has a different “time preference”. For most people, having a low time preference (prioritising the potential future over a certain present) requires a significant effort. However, whether it be investing money, building relationships, staying healthy, acquiring knowledge, or developing a career, among others, playing long term will allow for compounding (i.e. interest on interest), which will deliver higher benefits than if you are just focusing on the short term.
Nevertheless, there is value in striking a balance between having a long term goal but also allowing yourself to solve for the short-term. In the end, that you are alive now (the present) is one of the few certain things in life — just keep an eye on that longer-term path you are building for yourself.
Money makes money. And the money that money makes, makes money
The biggest challenge to thinking long term is that our brains are not really prepared to understand exponential functions (like that of compounding), which makes us underestimate them.
Probably the easiest way to illustrate this is to start with a hypothetical investment example. The S&P500 is the stock market index that measures the stock performance of 500 large publicly traded US companies.
[Note: If you want to invest money in this index you don’t have to worry about buying stocks of the 500 companies, instead you can literally buy exposure to the entire index using an index fund (or ETF) for as little as 0.015% APR of the invested amount. This also applies to other indices.]
$1,000 invested in the S&P500 in 1970 would have turned into $34,410 in 2020, and this does not even take into consideration the income from dividends! This outstanding return is not the result of a few years with extraordinary growth, but rather the compounding effect of growing at an average CAGR of 7.3% per year over 50 years. Your overall return is not 7.3% per year multiplied by 50 years (hence a ~367% return on your $1,000), but a 7.3% per year over a continuously growing base (because the return will build on the initial investment + last year’s 7.3% return), therefore your return after 50 years is effectively 3,341% on that $1,000 initial investment.
Fool me once, your fault. Fool me twice, my fault.
If you have ever moved you will have probably noticed that being accepted by the locals can be challenging. Locals are part of a particular social network — have known each other for years or even decades, and they have built trust over a long period of time. Unless they are certain that you have a long-term commitment to staying there, it will be difficult to enter this circle. Why? Basic Game Theory.
In a finite round game, there is little incentive for individuals to not be selfish because they will only be interacting for a set period of time. Therefore, there is a high risk that someone screws you at some point. However, when a game is played an infinite number of times it becomes apparent that you need to collaborate because if you try to rip off someone at any point in time, they will never be nice to you in subsequent rounds.
Back to the locals. When you have been living somewhere for a long time you become part of a community. If you behave well, your neighbours trust you and are more willing to help you when you need a hand, and you are also more willing to help them if they are nice to you. If, however, you are new, then that means that you do not enjoy this goodwill built on trust: if they do not know you, and they know you are there for a short period of time, they will fear you have no incentives to “behave” and comply with the social norms of that community.
When visiting a new city, what is usually the safest choice for lunch? The restaurant where you can see locals. Why? Because if you go to a place that is expecting one-time visitors (e.g. tourists), they will try to maximise returns (e.g. high prices for low-quality food). But it is difficult to sustain that business model with locals because you will not get any repeat business from them. As the saying goes — fool me once, your fault. Fool me twice, my fault.
Those who understand compound interest earn it, and those who don’t, pay it.
Unfortunately, compound interest also applies in the opposite direction and can harm us significantly.
A clear example of the negative impact of compounding is inflation. The whole idea behind inflation is that $1 today is worth more than $1 tomorrow. This should fuel consumption because whatever you do not spend today will be worth less tomorrow. $100 today under your mattress (or in a current account that pays no interest for that matter) will be worth $90 in 5 years with a 2% inflation rate, which by the way is the target held by most central banks.
People who misbehave and take advantage of others end up developing a bad reputation that precedes them, which can ruin their social and professional lives. You will be better off finding friends or business partners that want to stick around in the long run, and you should behave in the same way. If you associate yourself with someone who is in for a quick buck, chances are they will eventually cheat on you or your stakeholders (e.g. customers, suppliers, employees, friends).
Having a long term mindset does not mean you should never optimise for the short term. Your goals can be qualified by the time horizon they apply to — e.g. you might be saving to buy a house, but it’s probably a good idea to take a break and go on holidays from time to time. When you are in university you are solving for graduating and finding a good job, but that does not mean you should avoid making friends and having a good time just because it diverts time from studying. It is all about balance and you only live once.
Similarly, long term success comes from investing (your time, money, or mental capacity) wisely. It is extremely rare to get it right the first time, so there is a fair amount of iteration required until you are happy with the decisions you have made. You might change investments, jobs, houses, neighbourhoods, and even countries, several times before you are ready to commit. It is hard to decide what you like (and even more importantly, what you do not like) if you do not give it a go first.
For us, it has been eye-opening to realise the massive impact that making small but consistent changes can have over time, and this has triggered some adjustments in our lives:
- Expertise builds on experience: we are rethinking our careers as we consider the value of specialising in a particular area: the more you work on something, the more knowledgeable you are, which eventually drives more business, and the more you do of it, the easier it becomes.
- Trust builds over time: We are prioritising doing business with other like-minded, long-term thinking people. We want to have partners that work under the assumption that they will be there forever, which means they are more likely to treat everyone fairly.
- Returns build on returns: We want our savings to work for us, which is why we have invested a significant amount under the principle that “time in the market > timing in the market”. What this means is that instead of waiting indefinitely for a crash to happen to buy cheap, we have started to invest thinking of the very long term, where the differences in price today will have a minimal long-term impact.
