The power of compounding is one of the most powerful concepts in investing. Indeed, Warren Buffett (Trades, Portfolio) has been able to build the fortune he has today thanks to his understanding of this idea from an early age.
The great thing about compounding is that it does all of the hard work for you. All you need to do is find great investments (or buy an index fund) and invest accordingly. The money will take care of itself.
The one downside with compounding is that it takes time, which is unpalatable for those who want to get rich quick. However, for those investors who are will to sit back, relax and watch the money roll in, compounding is the perfect tool. Renowned value investor Mohnish Pabrai (Trades, Portfolio) took on this topic in a recent interview with Indian finance show ET Now.
Mohnish Pabrai (Trades, Portfolio) on compounding
Pabrai was asked about the current state of euphoria gripping Indian markets today and if investors should jump on the bandwagon to try to profit from a recent spate of IPOs. His reply was reasonably straightforward:
“Do not get envious because your stupid neighbor is tripling his money every three months and he is rubbing it in your face. Do not worry about that. Focus on long-term compounding. Focus on the 15% a year and those sorts of things. Do not try to do 15% a month. Generally speaking, you are going to hurt yourself more than you help yourself.”
But it’s not enough to just focus on compounding; you need to have what Mohnish calls “fluency on compounding,” a process which means, simply, the ability to be able to compound year after year:
“That is very important. Getting fluency on compounding is the reason why Warren Buffett is a billionaire and it is the reason why a number of people, even in India like Raamdeo Agrawal, have done so well. We have something known as the Rule of 72. The Rule of 72 basically makes it very simple in your head to figure out how long it takes money to double at different rates of return. Having this in your head in terms of how long it takes money to double at a particular rate of return is very fundamental. There are really three elements to becoming incredibly rich without doing a whole lot of work. The first is the amount of money that you save and that is very important, the second is the rate of return and the third is the length of the runway. We have control over two out of the three completely, we control the length of the runway and we control the amount we save.”
And when you have “fluency” it’s vital that patience follows suit:
“The most important thing after getting fluency on compounding is to have patience. We will not find investments every day or every month or every year. I mean if you talk to me right now. I can hardly find anything to buy in India. There are 5000 companies traded in India I can hardly find anything to buy and that is not a tragedy it is perfectly fine. There will come times in the future when we will have plenty of opportunities and the important thing is when those time show up, you should have the will and the resources to act on it.”
The fantastic thing about compounding is that it’s relatively easy to understand, but most investors struggle with the concept. Sitting around doing nothing is hardly the image most investors have when they think about the rush of Wall Street, but it is without a doubt the best way to make gains over the long-term. Sure, other methods are available, but considering how much time and effort is required to trade profitably, compounding is the easiest way.
These quotes from Mohnish might not be long or detailed, but they draw out the essence of compounding without adding any extra fluff.
Disclosure: The author owns no stock mentioned.
