Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” -Albert Einstein
Einstein was a fairly smart dude. The ironic thing is that there can be so much wisdom in ideas that are so simple. Just an added bonus: The brain doesn't like simple. This missive is to help real people with the simple math behind growing capital. In my opinion, the traditional investment products of today are just not designed to help people grow capital. In my opinion, you'll simply bob up and down with the market and that is just not acceptable to me. So mathematically how do we compound money? Let's first look at the chart below.
In the table above each portfolio achieved the same results + 50% or did they? If you add up each portfolio's return and divide by 5, you get 50%. But that is not how compounding works. If you look at the "Actual Total Gain" column, you will see that portfolio A actually achieved the largest portfolio gain, but in many years it had a very mediocre result when compared to the large gains in the other portfolios. However, they key is that portfolio A never suffered any large losses. While portfolio A is not realistic, what techniques can we employ to improve the realistic portfolio C? Instead of letting this portfolio experience a 40% and a 20% loss, what if we limit our loss in each of those down years to just a 10% loss? The actual gain for portfolio C goes from 15% to 94%! I hope your goal is becoming clearer. We want to hold on to our winning investments as long as possible and sell our unsuccessful investments as quickly as possible. Forget the "shiny lure" investment strategy to investment riches, rather focusing on a proper exit strategy is key to investment success!
Let's take the discussion a little deeper. What if I asked you, " Do you want 50% returns, 25% returns, or 10% returns?" Assuming I'm not from the government or a large bank/brokerage firm (so there is at least a chance I can be trusted), naturally you'd want 50% returns. I know I would. So in reality, 50% returns exist, but don't occur with great regularity. So the opportunity-set to generate consistent 50% rates of return is just not that great. For example, most will live to age 20, but only a few will make it to age 100. Let's think about high probability outcomes as opposed to low probability outcomes.
One key ingredient to compounding is to avoid large losses that was already covered, but another key ingredient is consistency. The idea of consistency gets us to my title about lay-ups versus three-pointers. Yes, for a three-point shot you get an added point for the degree of difficulty, but your percentage of success is going to be lower than the percentage of successfully made lay-ups. Let's put a few numbers to this:
If we compounded two 50% returns, we would end up with 125% total return. If we compounded four 25% returns, we would end up with a 144% total return. What would happen if we compounded a series of tiny 10% returns? Well, twelve 10% returns would end up compounding into a 214% total return.
Many individuals that I talk to are under the illusion that achieve great wealth in the stock market, one needs to be some kind of Babe Ruth of the investment world. Not true. You do not need to find the next Google or Microsoft. Consistent small wins will compound your money faster than irregular large wins.
Compounding!
P. Franklin, Jr.
June 2nd, 2017
All opinions and estimates included in this communication constitute the author’s judgment as of the date of this report and are subject to change without notice. This communication is for informational purposes only. It is not intended as an offer or solicitation with respect to the purchase or sale of any security. This information is subject to change at any time, based on market and other conditions. Any forward looking statements are just opinions – not a statement of fact.
Investing may involve risk including loss of principal. Investment returns, particularly over shorter time periods are highly dependent on trends in the various investment markets. Past performance does not guarantee future results.