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The Power of Compounding

by | Insights, Uncategorized

Albert Einstein supposedly once said that the most powerful force in the universe is compound interest.

The principle of compound growth can be defined as the power of exponential growth, that is, growth on growth.

The concept of compound growth and its impact can be a difficult one to grasp. Why is compound growth so important and how does it impact the returns achievable with an investment?

The power of compounding is basically the snowball effect that happens when growth generates even more growth and continues to do so. You receive growth not only on your original investments, but also on any interest, dividends, and capital gains that have accumulated — thus, your money can grow faster and faster as time goes on.

The late Dr. Albert Bartlett, a professor, author, and expert on arithmetic and exponential growth, painted an interesting picture as it relates to the power of compounding and exponential growth in one of his papers. An adaptation by economic analyst Chris Martensen explains Dr. Bartlett’s analogy like this: “Suppose I had a magic eye dropper and I placed a single drop of water in the middle of your left hand. The magic part is that this drop of water is going to double in size every minute.

At first, nothing seems to be happening. But by the end of a minute, that tiny drop is now the size of two tiny drops. After another minute, you now have a little pool of water that is slightly smaller in diameter than a dime sitting in your hand. After six minutes, you have a blob of water that would fill a thimble

Now suppose we take our magic eye dropper to Fenway Park and right at 12:00 p.m. in the afternoon, we place a magic drop way down there on the pitcher’s mound. To make this really interesting, suppose that the park is watertight and that you are handcuffed to one of the very highest bleacher seats.

How long do you have to escape from the handcuffs?

When would it be completely filled? In days? Weeks? Months? Years? How long would that take?

The answer is this

You have until exactly 12:50 pm on that same day — just 50 minutes — to figure out how you’re going to escape from your handcuffs.

In only 50 minutes, our modest little drop of water has managed to completely fill the stadium. But wait, you say, how can I be sure which stadium you picked? Perhaps the one you picked is 100 percent larger than the one I used to calculate this example (Fenway Park). Wouldn’t that completely change the answer? Yes, it would — by one minute.

Every minute, our magic water doubles, so even if your selected stadium happens to be 100 percent larger or 50 percent smaller than the one I used to calculate these answers, the outcome only shifts by a single minute.

Now let me ask you a far more important question: At what time of the day would your stadium still be 97 percent empty space and how many of you would realize the severity of your predicament?

The answer is that at 12:45 pm — only five minutes earlier — Fenway is only 3 percent full of water and 97 percent remains free of water. If at 12:45, you were still handcuffed to your bleacher seat patiently waiting for help to arrive, confident that plenty of time remained because the field was only covered with about 5 feet of water, you would actually have been in a very dire situation.

And that, right there, illustrates one of the key features of compound growth. With exponential growth in a fixed container, events progress much more rapidly toward the end than they do at the beginning.

We sat in our seats for 45 minutes and nothing much seemed to be happening. But then, over the course of five minutes—whoosh!—the whole place was full of water. Forty-five minutes to fill 3 percent; only five more minutes to fill the remaining 97 percent.” (Source: Martensen, Chris)

“The Crash Course: The Unsustainable Future Of Our Economy, Energy, And Environment”

Although this visualization doesn’t use money, it does show the incredible power of exponential growth and how growth on growth can have a slow and sneaky impact over time. In investing, the well-known “rule of 72” refers to a shortcut in estimating how long it would take to double your money based on taking 72 and dividing it by the compound annual growth rate.

For example, with a 10% compounded annual return, your money would double in 7.2 years.

How long it takes to double your money with an investment strategy matters, because the shorter the time period, the sooner the power of compounding kicks into high gear (see Exhibit 2 below). The sooner and steadier that growth occurs should lead to better long-term results.

Conversely, lower rates of return and higher volatility will lead to lower long-term results.

The hypothetical graph below shows the power of compounding for an investment with no volatility. You can see how compound growth takes time to start to have an impact.

Now imagine a large draw-down due to a bear market instead of the smooth, no volatility growth seen in Exhibit 3. Anything that causes a “reset” to a lower level, such as a large downturn in the portfolio, will weaken the eventual compound returns.

This principle is strongly interconnected with the second factor, the value of avoiding large losses. These two factors go hand in hand.

The power of compounding, crucial to successful long-term returns, can be better utilized when avoiding large losses.

The Value of Avoiding Large Losses

What do you call a market down 90%? It is a market that was down 80%, and then got cut in half from there.” – Meb Faber

Large losses can be incredibly painful in the short term, but even more dramatic is the impact on the long-term success of investment returns. There are many studies that show the value of avoiding large losses as well as studies that show how behavioral bias contributes to people continually and frequently participating in large losses.

Research has shown that most individuals are risk avoiders when handling gains, and risk takers when dealing with losses (Tversky and Kahneman, Judgment under Uncertainty: Heuristics and Biases, 1982).

Tversky and Kahneman conducted an experiment where:

  • People receive $1,000 with the choice of a guaranteed gain of $500 or a 50% chance of a $1,000 gain.
  • Over 80% chose the $500 guarantee, with few willing to take the risk of additional gain.

In the second part of the experiment:

  • People were given $2,000. 
  • They were then given the alternatives of a 50% chance of losing $1,000 or a 100% chance of losing $500.
  • Around 70% chose the chance of losing $1,000, with few unwilling to avoid the risk of a larger loss.

The results of the experiment indicated people tend to do the following when it comes to investing:

  • They don’t let their profits run and they fail to cut their losses short.
  • The reverse of this psychology is necessary to be a successful trader or investor.

As Warren Buffett once famously said regarding the rules of investing:

  • Rule #1: Never lose money. 
  • Rule #2: Never forget rule #1.

Disposition Effect

It is, of course, challenging for investors to avoid large losses. It is hard-coded in our DNA. This behavioral bias is called the disposition effect. The disposition effect is a behavioral bias wherein an investor exhibits reluctance to realize losses, as seen in the aforementioned experiment. Investors tend to sell winners too early and ride losers too long, hoping that they might eventually turn into a gain.

Studies by Shefrin and Statman (1985), Barberis and Xiong (2009), Odean (1998), and Weber and Camerer (1998), to name a few, have shown this disposition effect evident in investors’ behavior. This is despite the fact that large losses can occur much more quickly than large gains.

As the Oracle of Omaha once said: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

In the same vein as Buffett’s quote, you could replace the word “reputation” with “portfolio”, since large losses can quickly and disastrously wipe out years of investment growth.

With that in mind, you SHOULD do things differently and always address and define risk in such a way that large losses do not occur, or at least occur less frequently. For example; a solid 8% a year means you can double your money in 9 years (rule of 72). But if you take a 50% loss in year 10, you would be right back to where you started and the annualized return over those years would be 0%.

Reproduced from Advisor Perspectives