compounding

The Goal of Investing

I think a large part of the investment industry have lost sight of what really is the goal of investing.

If you ask most people what they are trying to achieve with their investments the answer is likely to be something along the lines of ..  "grow my money".  The average person is not striving to beat some index or to deliver attractive risk-adjusted returns.  Most people want a nice nest egg for when they retire, which means they need to protect and grow their capital at an attractive rate above the rate of inflation.  Remember the power of compounding.  

If you were to reverse the question and ask, what is it you want to avoid … I suspect the majority of people would answer .. "not lose my money".

Here are some of the problems I see..

Relative Returns

The industry is fixated on relative returns.  Everyone is trying [and most are failing] to beat an index.  The basic premise of this strategy is as follows .. over time the stock market rises at an attractive rate.  Therefore if you make a little more in the up periods and lose a little less in the down periods [ie your relative returns are better] then over time you'll have a lot more money than just sticking it in an index fund.  Even a few percentage points have a significant impact on a compounded number over the long term. 

The first issue is that the market doesn't always go up.  In fact a stock index can go for long periods of time with negative returns.  A few examples worth considering are Japan's Nikkei index and the S&P500.  The Nikkei peaked in 1989 at nearly 39,000 versus the current level of 16,700.  The S&P500 has spent quite a few periods of 10 years or more without positive returns.

"Investors can lose sight of the fact that the market has gone through long periods when returns were minimal.  During the 14 year period from the middle of 1968 to the middle of 1982 the S&P500 appreciated by less than 1% per year”  Lee Ainslee

"Say you were forty-eight years old in 1964 and put $100,000 into the Dow on the last day of 1964 with instructions that dividends be reinvested, confident that you would have a nice nest egg when you retired at age sixty-five.  When the last day of 1981 rolled around, your money would be worth statistically less than your initial investment because of a moribund market and the depredations of inflation" Leon Levy
 
“There have been periods of longer than a decade for which investing in the stock market in expectation of a 7 percent real return turned out to be a devastating mistake.  It took the market twenty-five years to regain its levels of 1929”  Andy Redleaf

Considering most investors think five years is a long time, an index fund or a relative return strategy, may not provide the returns your were hoping for.  

The second issue is that most individual investors don't get anywhere near the returns of the index regardless of the time in which they enter the market.  Numerous studies show that individual investors under-perform the index significantly either because they are scared out of markets during a downturn and/or are trading in an attempt to enhance returns.  

"In 2014, Dalbar released its 20th report QAIB (Quantitative Analysis of Investor Behaviour) and the results for the two decades are very instructive. From 1994 to 2013, the average return of investors in 14 equity funds was 5.02% compared to 9.22% for the S&P 500. Over 20 years, the total return to investors was 166% versus 484% for the S&P 500. This is an astronomical difference. And this shortfall is what might be called a "behavioral penalty." Francois Rochon

Most investors panic, sell at the lows and buy higher up when things are looking more favourable.  The psychology of the average investor almost guarantees under-performance.  An index on the other hand is unemotional and doesn't get scared out of the market at the bottom.  It rides out the lows.   

Thirdly, relative returns are not what individual investors want.  I'm sure the majority of investors would rather make 15% even if a market that was up 20% than lose 15% when the market was down 20%.  

Finally, minimising the downside is likely to help investors stay invested rather than be scared out of the market by a large negative return.

Asset Allocation

One of the industry solutions suggested to meeting an individuals investing goal is the asset allocation process    The general consensus is that if you are young, with a long time horizon for investments, you should have a high exposure to equities.  This is because equities have historically provided higher returns over a long period of time.   As you get older you should have less exposure to equities and more exposure to less volatile assets such as bonds.

In principle the equity assumption makes sense provided you are adding to your retirement account on the way through, which most people of course are.  Remember whether you lose 10% in year 1 or year 10 or 20, if the capital amount doesn't change you'll end up with the same amount in the end.   

But asset allocation has its own issues.  One issue is that most asset allocation models are rigid - such as 40% bonds and 60% equities.  In this case no-one is making a call on the relative attractiveness of the asset class.  The manager who gets the 60% equities exposure is generally required to be fully invested by virtue of his or her mandate.  She's supposed to be the expert on equities yet she can't go to cash if she can't find attractive investments.  Her best bet is to buy defensive stocks.  Unfortunately in a bear market there usually aren't many places to hide.

The bond manager who has 40% of the money has a few options.  She can move to shorter duration bonds to protect the fund from rising interest rates.  But if rates are very low, like they are now, it maybe difficult or impossible to earn attractive returns relative to inflation.  Time has not always been kind to bond investors.

“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital”  David Dreman

Looking in the rear view mirror the 40/60 portfolio has been a great performer over the last 30 odd years.  Bond yields have trended lower and equities, although volatile, have trended higher.  But driving with reference to the rear-view mirror is dangerous.   Bond yields are now at record lows.  The risk is now asymmetric in as much as bond yields can't fall much further but could rise a lot.  With yields so low they no longer provide an attractive income stream.   It's return free risk.  So don't expect the returns out of a 40/60 portfolio over the next 10 years to mirror the last 30 years.  It is unlikely to happen.

What do the Investment Masters do..

A major difference between the Investment Masters and most mutual funds is that the Investment Masters are FIRST trying to preserve capital before striving to make money.  This means they are focussed on absolute returns and not relative returns.  They are seeking to avoid the permanent loss of capital.  

The Investment Masters are not aligned with an index and have the ability to go to cash if opportunities are scarce.  They can build portfolios that are more durable than indexes.    While these portfolios may be unconventional they may be significantly more conservative.  

Conventional investing does not imply conservative investing.  A portfolio's historic performance can give a guide to how conservative it is but its future risk of permanent loss of capital is what determines how conservative it is.

The Investment Masters recognise that the cost of outperforming in down markets may result in under-performance in a bull market.  In the quest for higher long term returns the Investment Masters consider this a worthy price to pay.  

"We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%" Warren Buffett

Remember investment profits and losses are not symmetrical.  Consider the following two investment funds:

Fund A .. loses 50% in year 1, makes 50% in year 2 and then makes 10% in year 3
Fund B.. loses 50% in year 1, gets back to break-even in year 2 and makes 0% in year 3

Which would you prefer?    

Fund B should be your preference.  You get your money back.  Fund A is still down 17.5% at the end of year 3.  Profits and losses are not symmetrical.  To get back to break-even Fund A would have needed to make 81.8% in year 2 (not 50%) and then 10% in Year 3.  

Is you fund focussed on preserving capital?  Is your fund focussed on outperforming down markets and accepting of some level of under-performance in strong markets?  

 

 

 

 

COMPOUNDING SHORT STORIES - A KING, COLUMBUS and INDIANS

Compounding really is the magic of investing.  To be a successful investor you only have to do two things .. don't lose money and compound capital at a reasonable rate of return.  

The Investment Masters understand that losing money inhibits the power of compounding and that is why they focus on avoiding the permanent loss of capital as opposed to beating an index.

Below are some of my favourite excerpts on the power of compounding.  The story of the 'Peasant and the King' comes from the book 'Classics - An Investors Anthology' while the story of Columbus, the Mona Lisa and the Manhattan Indians come from Warren Buffett's early partnership letters.  The final short extract comes from a 2011 letter from Jeremy Grantham.

The Peasant and the King ['Classics - An Investors Anthology']

And then there was the king who held a chess tournament among the peasants- I may have this story a little wrong, but the point holds- and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third-and so forth. The king fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half million trillion kernels [18,500,000,000,000,000,000] or enough, if each kernel is a quarter inch long, to stretch to the sun and back 391,320 times That was nothing more than one kernel's compounding at 100 percent per square for 64 squares. 

[This story really does highlight the absurdity of achieving 100% returns a year.  Assume a 20 year old lives to 84 years [equivalent to 64 chess board squares of investing years] and starts with $1.  Doubling his stake every year the old man would end up with $18,500,000,000,000,000,000]

Columbus's Journey - The Joys of Compounding [Buffett Partnership Letter 1962]

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital.  Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter's rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that's $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

Mona Lisa - Joys of Compounding - Part II [Buffett Partnership Letter 1963]

Now to the pulse-quickening portion of our essay. Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu 4,000 converted out to about $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That's $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment.

However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound. Below are shown the gains from $100,000 compounded at various rates:

compund1.JPG

It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.

Some of you may be downcast because I have not included in the above table the rate of 22.3% mentioned on page 3. This rate, of course, is before income taxes which are paid directly by you --not the Partnership. Even excluding this factor, such a calculation would only prove the absurdity of the idea of compounding at very high rates -- even with initially modest sums. My opinion is that the Dow is quite unlikely to compound for any important length of time at the rate it has during the past seven years and, as mentioned earlier, I believe our margin over the Dow cannot be maintained at its level to date. The product of these assumptions would be a materially lower average rate of compound for BPL in the future than the rate achieved to date. Injecting a minus 30% year (which is going to happen from time to time) into our tabulation of actual results to date, with, say, a corresponding minus 40% for the Dow brings both the figures on the Dow and BPL more in line with longer range possibilities. As the compounding table above suggests, such a lowered rate can still provide highly satisfactory long term investment results.

Manhattan Indians - The Joys of Compounding Part III [Buffet Partnership 1964]

Readers of our early annual letters registered discontent at a mere recital of contemporary investment experience, but instead hungered for the intellectual stimulation that only could be provided by a depth study of investment strategy spanning the centuries. Hence, this section.

Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack.

Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.

So much for that.

Some of you may view your investment policies on a shorter term basis. For your convenience, we include our usual table indicating the gains from compounding $100,000 at various rates:

This table indicates the financial advantages of:

(1) A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah Technique)

(2) A high compound rate

(3) A combination of both (especially recommended by this author)

To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.

Finally, an extract from Jeremy Grantham's 2011 Letter..

I briefly referred to our lack of numeracy as a species, and I would like to look at one aspect of this in greater detail: our inability to understand and internalize the effects of compound growth.

This incapacity has played a large role in our willingness to ignore the effects of our compounding growth in demand on limited resources. Four years ago I was talking to a group of super quants, mostly PhDs in mathematics, about finance and the environment. I used the growth rate of the global economy back then – 4.5% for two years, back to back – and I argued that it was the growth rate to which we now aspired. To point to the ludicrous unsustainability of this compound growth I suggested that we imagine the Ancient Egyptians whose gods, pharaohs, language, and general culture lasted for well over 3,000 years. Starting with only a cubic meter of physical possessions (to make calculations easy), I asked how much physical wealth they would have had 3,000 years later at 4.5% compounded growth.

Now, these were trained mathematicians, so I teased them: “Come on, make a guess. Internalize the general idea. You know it’s a very big number.” And the answers came back: “Miles deep around the planet,” “No, it’s much bigger than that, from here to the moon.” Big quantities to be sure, but no one came close. In fact, not one of these potential experts came within one billionth of 1% of the actual number, which is approximately 10^57, a number so vast that it could not be squeezed into a billion of our Solar Systems. Go on, check it. If trained mathematicians get it so wrong, how can an ordinary specimen of Homo Sapiens have a clue?

Well, he doesn’t. So, I then went on. “Let’s try 1% compound growth in either their wealth or their population,” (for comparison, 1% since Malthus’ time is less than the population growth in England). In 3,000 years the original population of Egypt – let’s say 3 million – would have been multiplied 9 trillion times! There would be nowhere to park the people, let alone the wealth. Even at a lowly 0.1% compound growth, their population or wealth would have multiplied by 20 times, or about 10 times more than actually happened. And this 0.1% rate is probably the highest compound growth that could be maintained for a few thousand years, and even that rate would sometimes break the system.

The bottom line really, though, is that no compound growth can be sustainable. Yet, how far this reality is from the way we live today, with our unrealistic levels of expectations and, above all, the optimistic outcomes that are simply assumed by our leaders. Now no one, in round numbers, wants to buy into the implication that we must rescale our collective growth ambitions.