The power of compounding in Investing
In the Hindu epistemology, the change in time is characterized by yuga, each considers a few lakhs of years to complete. It kind of measures the age of humankind where the belief is that it also sets the entire physical world to collapse and recreate or rebirth into a new order. It’s a cycle that repeats creation to destruction and repeat. The description, however, of the end of each cycle seems dramatic and rapid which otherwise requires large energy to transform the entire world.
Now, geologists and scientists agree that the Earth has undergone massive changes and there are layers of frozen world. Most agree that Earth has experienced about five ice ages. Two people have greatly contributed to our current understanding of how ice age occurred on Earth. Serbian scientist Milutin Milankovic first proposed that the Earth’s position relative to other planets causing varying gravitational pull of the sun and moon that gently affects the Earth’s motion and tilt towards the Sun.
This is not as dramatic as it seems and these changes are gradual over tens of thousands of years which alters the solar radiation received on the Earth’s hemisphere. His theory is initially assumed that a tilt of Earth’s hemispheres caused bitter winters cold enough to turn the planet into ice.
Wladimir Koppen, a Russian meteorologist went further on the former’s work and discovered an important cog to make the process comprehending for us. He concurred that it’s moderate cool summers and not cold winters, were the cause for icy build up. His study pointed that a not-so warm summer which isn’t warm enough to melt the previous winter’s snow is the reason. A following winter would easily accumulate on the un-melted ice which increases the possibility of ice sticking the next summer.
A cycle thus sets in with further accrual of ice in the next winter and so on which weakens the warmth on Earth as more snow reflects the sun’s rays. Wham, within a few centuries a seasonal weather change turns into a climatic apocalypse. So, such enormous changes are occurred not due to huge inputs (energies) but small incremental ones over a long period of time. That’s what compounding does to even climate.
When we relate this to investing, the formula for compounding, the exponential lies in the time not the rate of return. While most of us always dedicate our energies in the process of generating higher returns, the success is achieved, however with the time spent in the investment. Though it’s proven and known, we’re (humans) good at linear thinking which is more intuitive than exponential thinking. Michael Batnick explained it so beautifully, “If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8*8*8*8*8*8*8*8*8, your head will explode (it’s 1,34,217,328)"
We spend more time in trying to make the best of our investment thesis, to generate more returns for this quarter, this year and may be for next year. What we lose sight is how to survive in the long run, for ten years, may be for twenty, thirty years and even more. Because, the more time one spends in the market, the possibility of higher returns is truer. Therefore, not many traders make money in the long run. They could just get lucky or one of their strategies works in a particular market.
If one is inconsistent with returns each year with higher volatility (deviation) then there’re chances of them not lasting for long as they could run out of the capital. This is one common outcome with many traders in the market. For traders, the goal is to find inefficiencies in the market and try to take advantage of it. But, for an investor whose goal is to create wealth in the long-run and timelines that run into decades, do not need spectacular higher returns but even compounded mediocre returns help amassing huge amounts of money.
This is what we’ve witnessed about Warren Buffet in our lifetime. Buffet very rarely has topped the charts as best performing investors in any given year, but he’s always remained the most successful and richest investor of all times. Morgan Housel credits the success of Buffet’s investing not to his skill but to time. So, while all of us have different risk appetites, for investing success that one trait common to all is time (to be given to an investment, to be spent in the market). That’s why it’s necessary to develop the temperament to not sway by the short-term market volatility but make sure one is viable for long. Returns are an output of such an effort displayed by the investors and at times they should remain immune to all the noise the market generates continusously.
This article was originally published in "The Hans India" daily on 11th Apr '22.