Issue 35: May 2022
Power of Compounding
I learned from my old mentor when you have a theme resonating with readers, you continue going back to the well. You find different insights or viewpoints, but you stay on theme. Everyone has a lot going on in their lives. Hopefully this weekend includes some traveling and/or relaxation. People spend 3-5 minutes reading this newsletter, if I am lucky enough to get them to open it. They then go back to their day-to-day lives. So if I sound like a broken record, that’s probably true.
With that background, let’s take a look at the recent declines in the stock market and see why it could be fortuitous for those of us with a long-term horizon.
Someone said compounding is the 8th wonder of the world. Maybe it was Einstein? Maybe it was Charlie Munger? Whoever said it was correct! In this issue I want to highlight the power of compounding and dollar cost averaging. Everyone investing in the market has experienced some pain in their portfolio over the last 6-9 months. Rather than be discouraged by the current decline, let’s extend our timeframe and see how current declines could actually be a good thing for those of us willing to invest over the long-term.
Let’s assume an investor has two potential scenarios.
In each Scenario the investor contributes $100,000 to open their investing account and makes $10,000 contributions per year (aka dollar cost averaging). Their accounts will return 7.5% per year with one important difference. In Scenario A, the investor experiences a 25% decline in Year 1. In Scenario B, the investor experiences a 25% decline in Year 10.
The psychological benefit of investing money and immediately seeing an increase in value can be intoxicating. The flipside is also true. Investing money and seeing it immediately decline in value can be demoralizing. However, these values represent just a moment in time. If you have a plan and can stick to it, the best outcome for long-term wealth creation is actually counter-intuitive.
As you can see, Scenario B does better up until the very end. This dynamic can be explained by the power of compounding. In Scenario A, the investor gets to invest for the next ten years at lower valuations stemming from the decline in Year 1. The opposite is true for Scenario B who sees a 25% decline in Year 10. Yes, it is painful to see $100,000 go to $75,000 over twelve months. However, that person had an additional $100,000 they invested over the next decade at lower valuations. This dynamic drove a 15% difference in total returns or ~$34,000 between Scenario A (~$266,000) and B (~$232,000). So what was painful in Year 1, proved to be fortuitous by Year 10.
Plenty of people invested in the markets in 2020-2021 and made money. Investing was easy. While that hasn’t been the case in 2022, it is part of the game. Returns in the stock market are non-linear. There will be ups and downs. As I have mentioned in the past, the ability to embrace these periods of volatility and think about the bigger picture is one of the greatest advantages we possess. If you are struggling to do that or interested in getting started investing now that the market has decline, please do not hesitate to reach out.