Wise investors let compounding work its magic

10 February 2013
By Teh Hooi Ling

I stumbled onto one of the Dow Theory Letters which was put up on my friend's website recently. It's entitled Rich Man, Poor Man.

That letter was about a few of the things an investor who is serious about making money should be aware of. The first is compounding. Now, I thought I knew all there is to know about compounding. Essentially, it is how your money will grow over time if you keep reinvesting your gains and allow them to grow as well. But the example given blew my mind away.

Here's the example:

Say there are two people - A and B. A starts saving at age 19. She saves $2,000 every year from age 19 until 25. Then she stops. In other words, she only puts $14,000 into her portfolio.

Person B, meanwhile, starts saving at age 26. And he is very disciplined. From age 26 until 65, he puts $2,000 yearly into his savings. By age 65, he has contributed $80,000 to his portfolio.

Now, let's assume A and B are able to generate 10 per cent on their savings and portfolios every year. At age 65, whose portfolio would be larger?

One would think B, yes? But here's the surprising thing. The difference in the portfolio size is quite negligible at age 65. By then, A's portfolio would be worth $944,641 and B's portfolio would be at $973,704. This, despite A only putting in $14,000 over seven years, while B has contributed $80,000 over 40 years!

That's the magic of compounding. The earlier you allow it to start, the greater the benefits. And you will really see its benefits from the seventh or eighth year onwards.

Here's what the Dow Theory says about compounding. "Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it.

"To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road.

"And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time."

There are a couple of other rules as well. The second rule from the letter is: Don't lose money. This is Mr Warren Buffett's No.1 rule in investing. His No.2 rule is: Don't forget rule No.1.

For you to achieve your financial goals, you must not lose big money. If you are confident that the underlying business of the company you have invested in is still sound, then don't sell in a crisis. That's when you will suffer big losses. If anything, you should put more money in.

Here's another set of mathematics. Say you have invested $10,000 in a stock that was trading at $1 each. So you have 10,000 shares. It plunged by 50 per cent to 50 cents, and your portfolio is now worth $5,000. For you to recoup all your capital, the stock has to climb 100 per cent from the 50 cent level.

But if at 50 cents, you put another $10,000 into the stock, you'd be able to purchase 20,000 shares. Now you have a total of 30,000 shares. With 30,000 shares, you only need the stock to climb by 33 per cent - from 50 cents to 67 cents for you to recoup all your investment. Beyond that, it's profit.

A word of caution is appropriate here. This strategy should only be used for a stock whose underlying business remains strong, one that you believe will bounce back. Its share price has slumped because it is merely going through a bad patch or it is affected by bad market sentiment.

For stocks which have no hopes of recovery, such a strategy is equivalent to throwing good money after bad. And that is not a wise move.

The third set of maths has to do with probability. You should only put your money in investments which have a high probability of giving you a decent return. You wouldn't want to put a lot of money into something that has a one in a million chance of winning, even if the winning sum is huge. Mr Buffett's strategy is to bet big on high probability events.

And finally, certainty is not necessarily good. What is an investment? Investing is forgoing consumption now in order to have the ability to consume more at a later date. In other words, your investments must give you a return that beats the inflation rate.

"Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period," said Mr Buffett in his letter to shareholders last year.

On the other hand, a non-fluctuating asset can be laden with risk. Currency-based instruments such as money-market funds, bonds and bank deposits were once thought of as "safe". But over the past century, these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.

In the US, for example, the dollar has fallen a staggering 86 per cent in value since 1965. It takes no less than US$7 today to buy what US$1 did at that time, noted Mr Buffett.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments - and indeed, rates in the early 1980s did that job nicely. "Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume," he said. "Right now bonds should come with a warning label."

In short, successful investing is about making your money grow faster than inflation, minimising your losses and allowing compounding to work its magic.

hooiling@sph.com.sg

Link
http://www.straitstimes.com/sites/straitstimes.com/files/ST_20130210_MONEYWISE10_3520409.pdf