A recent episode of the “Invest Like the Best” podcast got onto the topic of compounding. Investor Patrick O'Shaughnessy and doctor Peter Attia agreed that in fields as different as health and longevity, and investing and finance, compounding plays an enormous, and often underappreciated role. “All the best investing advice is fairly straightforward and very boring, because it needs time to work,” O'Shaughnessy said. “All the fun comes at the latter half. Everyone uses the example of [Warren Buffett], who wasn’t a billionaire until he was 65. And now he’s [worth] $80 billion-because of compounding. It's so hard when it comes to health to convince yourself of that, because it’s so easy to eat a cookie today, and especially when you’re young, [and] really feeling no ill effects of that. It’s all about simple daily decisions.” Attia agreed, saying “For no human can compounding be truly intuitive, because it’s just so non-linear. We tend to think a lot of the things that go wrong [such as a heart attack or cancer] appear suddenly. We have to remember that none of those things happened suddenly. A cancer spends 80% of its life undetectable, because it is just simply so small. Heart disease begins at birth.”
In an age when seemingly everybody is looking for the quick fix, the shortcut, the hack, to quickly and easily achieve difficult goals, it is of primary importance to see this human tendency for what it is-a lie. The core tenant of compounding is that good decision making and behaviors, when consistently applied over long periods of time, compound to create surprisingly large positive outcomes. Compound growth is exponential, which is difficult for the linear-thinking human brain to grasp. If you asked a room full of people to guess how much a penny would be worth in 30 days if it doubled everyday, the average guess would be vastly smaller than the actual answer: $5,368,000. What’s interesting is to see the progression of the growth over the 30 days. On day 10, you would only have $5.12. But by day 20 you would have $5,200. By day 25: almost $168,000. From there the growth is almost hard to believe:
Day 26: $335,500.
Day 27: $671,000.
Day 28: $1,342,000.
Day 29: $2,684,000
Day 30: $5,368,000
As can be seen, the truly exponential growth occurs in the last few years. Admittedly, nobody is going to double their money everyday. But the point remains: today’s positive actions, whether resisting the impulse to spend money frivolously or not adopting a speculative or unproven investment approach, takes effort and discipline, and the payoff is decades in the future.
When it comes to your financial life, building an appreciation for compounding is the first step toward improving behaviors. Small increases in savings rates, a focus on the reduction of fees and taxes, working to achieve modest improvements in annual investment returns, and elongating your time horizon, can result in profoundly improved financial outcomes. However, just like losing weight, we need to resist our innate desire for the quick fixes and the fads and focus on adopting the right tenets and principles to let compounding work for us.
The first is managing cash flow. The reason so many great investors tend to be frugal, is their deep appreciation for compounding. Just think of famed investor Shelby Davis’ reaction to his grandson’s request to buy him a $1 hot dog at a street vender. “Do you realize that if you invest that dollar wisely, it will double every five years?” Davis exclaimed. “By the time you reach my age, in 50 years, your dollar will be worth $1,024. Are you so hungry you need to eat a $1,000 hotdog?” Though extreme, the point is a good one. An intuitive grasp of compounding provides the incentive and discipline to reduce needless spending and delay gratification.
With investing, the point is the same. Adopt a logical, disciplined, long-term, and patient investment approach. Work to reduce turnover, costs and taxes. Invest prudently-nothing gets in the way of compounding more than large losses. Remember that if your portfolio loses 50% you need to make 100% to get back to even. Avoid getting caught up in envy, fear and greed. Do not chase investment fads. Work on improving your emotional balance. Remind yourself that the stock market is a fantastic place to build wealth over the long-term, put a dangerous one to try and get rich quick. Realize that, with a long enough time horizon, even modest amounts of capital growing at unheroic rates can compound to very large amounts given enough time.
The last point I’ll make is: start today. Avoid negative interia and myopia. Don’t think that the power of compounding can't work for you because you waited too long. Most people have a longer investment time-horizon than they realize. Modestly changing behaviors today, and adhering to them over time can have pronounced effects with even a ten year horizon. Work with an advisor who understands that sound financial planning and investment management is a long-term game centered on keeping their clients disciplined and accountable, and helping them keep their eye on their long-term goals.
ryanpdolan@dolanpartners.com