Investing’s Real Magic Formula: Compounding

Investing’s Real Magic Formula: Compounding

“When it comes to saving, investing, and the power of compounding, starting earlier is better – a lot better.”
– Joel Greenblatt

The quote is not taken from Joel Greenblatt’s The Little Book That Beats The Market, where he outlined the Magic Formula, but rather from his new book: Common Sense: The Investor’s Guide to Equality, Opportunity, and Growth. While this new book from Greenblatt tends to focus on socioeconomic issues, there are some important financial and investing lessons sprinkled in throughout.

In chapter 6, Greenblatt drives home the importance of investing early, the power of compounding and long-term investing by giving the following example of two investors (courtesy of an excerpt on ValueWalk):

Investor A: Starts investing $2000 a year at the age of 26 and contributes $2000 a year until the age of 65. Achieves a 10% annual return.

Investor B: Starts investing $2000 a year at the age of 19 and contributes $2000 a year for the first seven years until age 26 and then doesn’t contribute thereafter. Achieves a 10% annual return.

Who ends up with more at the age of 65? According to Greenblatt, it’s Investor B. It seems impossible that Investor B, who made just seven contributions and stopped after that, can have more or anywhere close to the amount of money compared to Investor A, who started later but went on to make forty $2000 contributions. The example highlights the power of long-term compounding.

66% Per Year vs. 22% Per Year?

Imagine you were presented with two different investment options – one that has returned 66% per year, and another that has returned 22% a year. Which would you choose?

This is obviously a trick question, but the important question is the time period for both returns.

This was a point top financial blogger Morgan Housel recently pointed out using Warren Buffett’s long-term results compared to the best performing hedge fund of all-time, Renaissance Technologies (RenTech). While both returns are amazing, Buffett’s annualized historical return is about a third of RenTech’s mind-blowing annual 66% return since 1998, but since Buffett had a 23-year head start the base that Buffett is compounding off of is exponentially larger. Housel writes, “Currently, at 90, he [Buffett] has a net worth of more than $81 billion. A large portion of that, however, was accumulated after his 50th birthday. And $70 billion came after he qualified for Social Security benefits, in his mid-60s.” The chart below shows Buffett’s net worth over time.


Compounding is Backloaded

The Buffett example above looks great on paper, but as Ben Carlson and Michael Batnick recently pointed out on their Animal Spirits podcast and in this follow up blog post, the benefits of compounding don’t always come as easy as they may sound. Their lead in as compounding being “overrated” is a bit tongue and cheek, but they highlight some important checks and balances when thinking about compounding and what it takes to achieve all it’s benefits. For instance, they say:

  • The big benefits of compounding come way far out in the future, which makes it hard to see;
  • Saving when we are young is difficult;
  • Saving when we are making money is also difficult, since often times the more money we make the more we tend to spend.

The Compounding Power Of Compounding

Albert Einstein is reported to have once said, “Compound interest is the eighth wonder of the world.” Of course, not everyone is wired in a way in which they see and understand things like Einstein, Buffett or others mentioned in this article. But maybe there is more that can be done in order to help investors save for the long-term and truly grasp the power of compounding. Things like financial education, incenting savings for young investors, and more nudging around the benefits of funding retirement accounts and 401Ks are all things that may help. For example, the IRS has IRA catch-up provisions, which allow investors over the age of 50 to contribute more toward their IRAs in an effort to “catch-up” on saving for retirement. What if you flipped it upside down and allowed very younger savers, say 30 or younger to have “lead up” contributions where they could put more in their IRAs earlier, if feasible, allowing for more compounding potential.

Here at Validea we’ve spent nearly 20 years studying great investors and their investment methods. But regardless of what those methods are, they all need time to show their true value. As Buffett’s returns have shown, when it comes to achieving your long-term investing goals, time in the market often trumps the annual rate of return and most every other factor.

Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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