The joys of compounding

In this post, I hope to explain why I invest and why you should consider investing yourself. (Assuming you don't do so already.) It can be boiled down to a single word: compounding.

Albert Einstein is said to have described compound interest as the "most powerful force in the world". As Jason Zweig points out, we should be concerned about the veracity of this quote — nevertheless, compounding is very powerful. 

Warren Buffett provided the table below to his early investment partners in the 1950s and 60s. It shows the gains from a $100,000 investment compounded at different rates over 10, 20 and 30 years.

	4%	8%	12%	16%
10 Years	$48,024	$115,892	$210,584	$341,143
20 Years	$119,111	$366,094	$864,627	$1,846,060
30 Years	$224,337	$906,260	$2,895,970	$8,484,940

Compounding involves constantly reinvesting the interest earned from an investment. Over a long period of time, this interest on interest adds up to a great deal. Because we are all impatient, compounding is deeply under appreciated.

When Buffett started his partnerships in 1956, at the age of 26, he was already independently wealthy — having about $174,000 in personal savings, $1.6 million in today's terms. When you consider that the Buffett partnerships — of which Warren was the largest investor — compounded at 29.5% between 1957 and 1969, and that shares in his subsequent investment vehicle, Berkshire Hathaway, compounded at 20.8% between 1965 and 2016, it is unsurprising that he is now one of the richest men in the world.

While we obviously aren't going to be able to touch Buffett's record, we can still take away a few important things from his success. There are three important parts, which the table above helps illustrate. Firstly, to best take advantage of compounding, we need to start early. (In the womb, if possible.) To maximise our wealth, we need to try to compound it at the highest possible rate. Finally, like Buffett, we need to live a long and happy life.

All of this brings me to another important question: why invest in stocks? Over the long-term, Australian stocks have compounded 8–10 per cent per annum, depending on which dates you look at. Over the last 20 years, the gross return (i.e. before tax) has been 8.5%. Unlike property — unless you are very rich — you don't need to borrow to get started, either. If we assume that rate stays the same, $1,000 invested now will grow to $60,000 over the next 50 years. If we can invest better than the market — either through a good fund manager or our own stock picks — and boost the compounding rate to 11%, that $1,000 turns into $184,500.

Something to remember next time you're considering a big purchase.

Setting up stumps

I should start my describing my investment philosophy and my motivations for starting this blog. Value investing has its roots in the teachings of Benjamin Graham and David Dodd. It has four central ideas that I'll touch upon briefly. Here, I borrow from Li Lu, who described these key ideas in a speech to students in 2015.

The first and most important concept of value investing is that stocks represent fractional ownership of businesses. It might seem obvious, but many, if not most, individual investors don't invest this way — they focus instead on stock prices and their movements. Investors, as Li Lu rightly points out, should expect to "earn what they deserve". If a business is flourishing, as owners, they will benefit from their participation; if it is foundering, the inverse is true.

Second, value investors see the stock market as servant rather than master. The best way to understand this is through Benjamin Graham's concept of Mr Market. As Jeremy Miller writes in his book "Warren Buffett's Ground Rules":

"The idea is that a securities market can be thought of like a moody, manic-depressive who stands ready to buy or sell you a half stake in his business every day. His behaviour can be wild and irrational, and is difficult to predict. Sometimes he's euphoric and thinks highly of his prospects. Here he'll offer to sell you his stake only at the highest of prices. At other times he's depressed and doesn't think much of himself or his business. Here he offers to sell you the same stake in the same business at a much lower, bargain price … While you can never be sure what mood you will find him in, you can be sure that regardless of whether you trade with him today, Mr. Market will be back again with a new set of prices tomorrow."

In other words, while the market can tell you the price of a security at any one point, it can't tell you its value. You have to work that out yourself.

The third idea is that investing relies on predictions about the future. The future is uncertain and humans are inherently bad at making predictions. To counter this, we need to leave a large buffer between the price we pay and the company's intrinsic value — this is known as a "margin of safety". As Li Lu says:

"Because we have the first principle, we know that the stock is a fractional interest in a company, and that company itself has an intrinsic value. And because we also know that the market is there to serve us, we can wait to buy until the price is far, far below the company's intrinsic value. And when the price far, far exceeds the company's intrinsic value, you can sell. This way you won't lose much money if your prediction of the future is wrong … And if you do turn out to be right, your return will be much higher than others."

The fourth key idea is that investors should stick to situations where they can make reasonable, conservative assumptions about a business's future worth. Once again, this seems obvious, but many investors stray far beyond their circle of competence. People like myself, with very basic investment experience, should stick to the few businesses, industries or situations they can adequately understand. This might seem dull for the many market participants who look for "action", often in the most overvalued and risky places, but it is the only course for the value investor. Buffett, for instance, famously eschewed technology businesses for most of his career — it didn't stop him from amassing the greatest investment track record of all time. To return once more to Li Lu:

"If there are things you don't understand, or if you have any kind of psychological or physiological weakness, there will be a situation in the market that exposes you."

Having outlined my investment philosophy, I'll now turn to my motivations for starting a blog.

The truth is, I haven't always followed the wisdom of value investing that I've outlined. While I have had satisfactory results in the three years since I bought my first stock, I suspect this is largely due to good fortune rather than my skill. Indeed, when I first started out, I could barely read a balance sheet or income statement. This blog will help my keep my decision making, and investment results, accountable. By keeping a written record, and revisiting my mistakes and my successes, I hope to hone my investment skills and processes over time. Perhaps others interested in value investing will be able to glean something from my writings, too.

Thanks for reading. Hopefully my next post isn't too far away.