Contents
Morgan Housel’s The Psychology of Money – Timeless Lessons on Wealth, Greed, and Happiness is one of the thought-provoking books listed in the Books section of this site. Chapter 4 entitled Confounding Compounding touches upon why compounding can be difficult.
The counter-intuitiveness of compounding may be responsible for the majority of disappointing trades, bad strategies, and successful investing attempts.
Good investing is not necessarily about earning the highest returns. This is because the highest returns tend to be one-off successes that cannot easily be replicated. Good investing is much more along the lines of generating reasonable which can be repeated for the longest period.
Rule #1 Of Compounding
Charlie Munger and Warren Buffett (Berkshire Hathaway) have often stated that one of the most crucial aspects of generating wealth is to never interrupt it unnecessarily.
Many investors would agree this makes perfect sense. These same investors, however, do not always have what it takes to leave well enough alone. Perhaps it is human nature to think that activity is necessary to generate superior results.
This, however, is not necessarily the case.
For the vast majority of retail investors, the best way to generate long-term wealth is to make the right decisions and then to avoid interrupting the compounding process unnecessarily.
The following are 3 key reasons why many investors fail to create wealth.
Compounding Is Not Intuitive
How many times have you seen a graph showing how the value of an investment experiences parabolic growth the longer the holding period?
The compounding formula is relatively simple but most people are wired to believe exceptional results require extraordinary efforts.
We can think of many things in life that require considerable effort in order to excel at a specific task. This is because we do not generally become highly proficient at something unless we do the right things repeatedly.
When it comes to investing, however, great results often come from doing very little (or nothing).
I very briefly belonged to an ‘investment club’ almost a decade ago. One particular individual was a relatively active trader and tried to convince other members to employ the use of short-term out-of-the-money option contracts.
His recommendations made sense in theory so I tried them. I experienced moderate success but found that I was spending far too much time managing a few investment positions. I also found my mindset changing from being a long-term investor to a short-term investor. I, therefore, relatively quickly discontinued writing short-term covered calls.
Success Seems Too Far Away To Feel Real
Most people focus on what is likely to occur in the short-term. It is just human nature.
Think about a major decision you must make today that will impact your life within the next 6 – 12 months. Now, think about that same major decision but the impact will not be felt until decades later.
Unless your mindset differs from most people, you are likely to focus more on how your decision will impact your life in the relatively short-term. Something that is much further out on the calendar generally feels less real thus making it easy to ignore.
Heck, we don’t know what life will bring. We may not even be around decades from now!
For compounding to work, however, we must focus on the impact our current investment decisions will have on our investment results decades into the future. Essentially, our investments must be left undisturbed for a very long time. Many people, however, will fail to stay the course because we are unable to easily emotionally connect with the distant future.
How Do We React When Life Gets Tough?
Unless you are unique, your life is likely to experience highs and lows. ‘Stuff’ happens. Often times, this ‘stuff’ is completely out of our control.
The current environment is a great example.
Over the years, Charlie Munger and Warren Buffett (Berkshire Hathaway) have often advised investors to:
Invest in a business any fool can run, because someday a fool will.
I suspect their sage advice extends to country leaders.
While we manage our finances based on certain assumptions, these assumptions can very quickly turn on their head. When this occurs, how we react is a true testament of how we react when life gets tough.
Do you panic when we experience a major pullback? Are you apt to ‘throw in the towel’ when the value of your investments plunge because you can’t handle the ‘stress’?
OR
Are you inclined to view corrections as healthy?
I am certainly in no position to pass judgment on anyone’s investment decisions. I merely suggest we calm down and think rationally before succumbing to any rash decisions that could have some very serious ramifications.
If your investments are of high quality and you have the wherewithal to withstand ‘stuff’, the current market turmoil should not phase you. The world has previously experienced worse things and somehow we have muddled our way through.
We will likely continue to experience short-term turmoil. If we do not interrupt our investments unnecessarily, however, their value should be far greater decades later.
If you invest in great companies with exceptional management that allocate capital efficiently, the current market correction presents a ‘golden opportunity’ for your investments to appreciate significantly in value. This is because during times of turmoil, great companies can:
- make strategic acquisitions at more favorable valuations;
- repurchase a greater number of attractively valued shares; and
- benefit from weaker competitors falling by the wayside.
Final Thoughts
Start investing early, stay consistent, and let time work in your favor. In addition, avoid counterproductive behavior such as:
- trying to sell before the next recession;
- trying to buy just before the next bull market;
- “repositioning” portfolios based on what is supposed to do better in the new paradigm; and
- dumping stocks during a downturn which deprives us of the ability to eventually recover.
Resorting to counterproductive behaviors in the face of heightened concern and uncertainty is precisely why compounding can be difficult; it is human nature to think that active investing may lead to superior results.
Making irrational spur of the moment investment decisions when your investments are ‘blowing up’ can crystallize losses.
Depending on your circumstances, getting ‘out of the way’ of your investments is the best course of action. Better yet, strategically increase your exposure to great companies when they temporarily fall out of favor.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
