The power of compounding may be one of the most important principles for investors, but also appears to be one of the most misunderstood.
Compounding is known as the eighth wonder of the world, but there has been a growing chorus of professional investors who claim that most stock market participants are no longer interested in long-term investing and the long-term benefits of compounding.
Compounding: What Is it Good For?
Most of the world’s most revered investors have made their fortunes over several decades and they would not have been able to do this without compounding.
Today, stock market participants are becoming increasingly focused on the short-term. Hedge funds report results quarterly, or even monthly, companies report quarterly and most asset managers are judged on only a few years of performance, which is hardly enough time to judge their skill accurately when bull/bear markets can last for more than five years.
Understanding how the power of compounding can help improve your returns through both the effect it has on your portfolio and how it can help you reduce tax liabilities is the single most important key to long-term wealth creation.
My favorite study, which shows how important compounding and by and hold investing is for the average investor, comes from a document (Timeless Wisdom for Creating Long-Term Wealth) that has been put together by Davis Advisors, the $40 billion mutual fund powerhouse founded by Shelby Davis -- the son of Shelby Cullom Davis (you can read more about Shelby Cullom Davis here).
The chart below, which is take from the document, illustrates how four different investor reactions to a market correction can impact returns.
Four hypothetical investors each invested $10,000 in the market from January 1, 1972, to December 31, 2013, but all four investors acted differently during the 1973 to 1974 bear market.
The Nervous Investor sold out and went to cash. The Market Timer sold out but moved back into stocks on January 1, 1983, at the beginning of a historic bull market. The Buy and Hold Investor held steady throughout the period. And lastly, the Opportunistic Investor realized that the bear market had created opportunities and contributed an additional $10,000 to his original investment on January 1, 1975.
This chart shows more than just the benefits of compounding. It also highlights the stupidity of market timing. The chart clearly shows that trying to time the market will severely impact your long-term returns -- there is plenty of other research on the topic of market timing out there that reaches the same conclusion.
Compounding will revolutionize your investment returns and one investor who understood the benefits of compounding was traditional value investor Walter Schloss.
Walter Schloss and the Power of Compounding
Walter Schloss, or cigar butt Schloss, was one of the few value investors who continued to follow Benjamin Graham’s teachings right up until his death in 2012. While the rest of the market moved on to more exotic trading strategies, Schloss continued to buy net-nets and generated a very handsome return for himself and clients while doing so.
For the 33 years ended Dec. 31, 1988, Schloss earned a compound annual return of 21.6% per year on equity capital for his investors. Warren Buffett (Trades, Portfolio), in comparison, made 23% per annum for the 24 years to 1988.
Walter Schloss understood that he was not the world’s greatest investor (despite his stellar returns), he attributed most of his success to the power of compounding.
The one style of investing Schloss knew and knew well, was deep value investing. He understood balance sheets and how to look for value. But, he acknowledged that this approach was never going to yield outstanding returns in any one year. However, the power of compounding would, over time, yield the desired results. In a lecture to students at the Columbia Business School, Schloss stated:
“...Peter Lynch visited literally thousands of companies and did a superb job in his picking. I never felt that we could do this kind of work...therefore, went with a more passive approach to investing which may not be as profitable but if practised long enough would allow the compounding to offset the fellow who was running around visiting managements...I also liked the idea of owning a number of stocks. Warren Buffett (Trades, Portfolio) is happy with owning a few stocks and he is right if he’s Warren but when you aren’t, you have to do it the way that’s comfortable for you and I like to sleep nights…”
The table below shows Schloss’ returns between 1956 and 1984. You can see that Schloss’ returns were not consistent or steady, but over time they added up to produce tremendous results.
Summary
By sticking with the same strategy and appreciating the effect compounding would have on his portfolio, Schloss was able to achieve returns that were more than double the average return of the market over the same period. An excellent example of the magic of compounding in action.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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