One of my favourite financial concepts is compounding, i.e. the ability of an asset to generate money, which is then reinvested in order to generate more money. A common example which illustrates it is buying shares and deciding to reinvest any surplus (due to the shares increasing in value) instead of drawing it as dividends. This is called investing on an accumulation basis and it means that your surplus is used to buy more shares which in turn might also increase in value, creating more surplus to be reinvested, and so on.
The compounding effect doesn’t just apply to finance and it is not always positive. Darren Hardy, the author of the book The Compound Effect, describes it as “the ripple effect you get from the choices you make”. Sometimes the choices we make daily can seem insignificant because we don’t see an immediate effect from them. However, over time these choices, if made consistently, can have a huge impact on our lives and businesses.
My partner and I used the power of the compound effect to shave off 10 years of our mortgage in just two years by consistently making overpayments. At first the difference our overpayments made in terms of money saved on interest was minimal, just a few pounds per month. But we kept doing it for two years and overall saved thousands of pounds in interest over what would have been the original length of the mortgage.
Think about your life and business and ask yourself what action could you take on a consistent basis which would make a significant difference? I will share two ideas below.
Pay yourself first. Without fail, without excuses. Set a direct debit every month for a specific amount to go to a savings or investment account as soon as you receive your salary or other income. Do not wait until the end of the month to see if there is anything left to save or invest, chances are it won’t be. I worked with a client who decided to pay themselves £200 every month which they invested in shares. They also made a commitment to invest a certain percentage of their bonus. One year has passed and they now have over £5,000 in their investment pot. Not bad.
Perform regular money check-ups. Whether you run a business or not, it is a good idea to set some time aside at regular intervals to review your finances. I do this weekly, usually on Mondays. Monday = money day. Some people do it on Fridays. Friday = finance day. You can do it whenever you want as long as you do it consistently. Check your account balance, analyse your spending and look for patterns, send reminders for upcoming or overdue invoices, etc. Over time you will have a healthier cashflow, a better idea of what you tend to spend most money on and how profitable or damaging that habit is. If you run a business you will also be better equipped to forecast and identify and allow for seasonality.
Now think about the things you are consistently doing at the moment. What effect do they have on your financial life or the financial situation of your business? It’s hard to identify these actions because of the trivial effect they have if performed only once. But don’t be fooled: every little thing you do every day will reach a tipping point where it impacts you greatly.