Ramesh was relaxing on a Saturday, with a hot cup of coffee and a book of mathematical puzzles. Suresh comes into his room, smiles and asks Ramesh why he was reading books ‘meant for kids’!
Ramesh smirks and asks Suresh to solve this simple puzzle: ‘There is a pond where a magical lotus used to grow. It had a magical property to double in size every day. If it could occupy an entire pond in 30 days, in how many days will it cover half the pond’?
Suresh with an arrogant look answers, ‘Obviously in 15-16 days!’
If you, the reader also agree with Suresh… You’ve failed to take into account the concept of Exponential Growth!
This story illustrates our lack of understanding the concept of Exponential Growth. Let us understand about the same in this edition of Money Wisdom.
We understand linear growth intuitively but are unable to make sense of exponential or percentage growth. Humans through the evolution process were not conditioned, exposed or didn’t even evolve enough to understand this concept intuitively!
From a financial perspective, there are countless examples and ramifications of not being able to understand the impact of Exponential Growth:
1).When it comes to understanding the impact of inflation, people feel a 7% rise in expenses over the long term would be manageable, but we fail to appreciate that it means your expenses doubling every 11 years. By the time an average young person would retire, his expenses would have gone up multi-fold.
2).Many investors, especially young, undermine investing small amounts regularly, thinking that it won’t move the needle of wealth creation in their lives. However, investing just Rs.2000 every month for 25 years (assuming a ‘moderate’ return of 12%) would amass a corpus in excess of Rs.34 lakhs! (For illustrative purpose only).
3).Even professional investors & financial analysts show their disregard for this concept. During the global IT boom of 2000, the valuation reports built in high rates of growth over long periods of time, little realizing that the power of compounding would add up to absurd assumptions. ^
Thus, the advice to follow, for matters financial and non-financial:
1). We should not trust our intuition and always keep a calculator handy to calculate and appreciate trends in life and business.
2).Compound Interest is an example of this ‘phenomenon’ and its impact should never be undermined on our lives (especially in financial matters).
For those who are still grappling with the lotus puzzle, think again, if the lotus was going to cover up the entire pond in 30 days, it means the lotus was half the size the previous day!
Let’s watch this video where Rolf Dobelli explains us about this bias and how not to be a victim of the same.
^ For e.g. The famous investor David Dreman had explained that the company AOL would need 18 billion subscribers, roughly three times the earth’s population (at that time), to justify the premium valuations it commanded in 1999!
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