What do you think the main driver of long-term wealth creation is? Your job, profession and salary, your education, inheritance, hard work and resourcefulness, living within your means, savings or something else? Of course, all these things matter and play an important role, but for most of us who invest I would argue it’s the power of compounding over long periods of time that is the most powerful force in building wealth.
In my previous article, “The Silent Hero in Your Investment Portfolio,” I explored the powerful concept of compounding and how it quietly fuels the growth of your investments over time. Building on that, I thought it would be good to think deeper into strategies and concepts that can help you harness the potential of compounding to achieve long-term financial success. From starting your investment to optimizing your tax strategies, each point plays a significant role in making compounding work for you.
1. Getting Invested to Begin With
The first and most crucial step in leveraging compounding is simply getting started. Too often, individuals delay investing in the market or other assets, waiting for the “perfect” time or just don’t understand the powerful concept of compounding. As they say, time in the market is far more important than trying to time the market. By starting early, even with small contributions, you allow your investments to enjoy the maximum benefit of time, enabling compounding to work its magic over extended periods.
Here in my home state of Connecticut, high schools will require all students to take a personal finance and financial literacy course (starting in 2027) in order to graduate (see the announcement). This is a good step in teaching younger adults the importance to saving and investing and the power of compounding.
2. Stock Price Appreciation
When you invest in stocks, you can make money through share appreciation or dividends (more on that below), and while many stocks don’t end up appreciating if you hold a diversified basket of securities you are likely to have some significant winners that should overcome the losses and give you a return. But these returns aren’t short-term in nature, because the true power of compounding lies in patient, long-term growth. Seek out quality companies with solid fundamentals and competitive advantages. These companies are more likely to experience steady stock price appreciation over time, facilitating compounding at an accelerated pace. We’ve done lots of interviews with Kai Wu of SparkLine Capital, David Rolfe of Wedgewood Partners and Gene Munster and Doug Clinton of Deepwater Asset Management talking about how they seek out firms with durable advantages and value.
3. Dividends / Income
Berkshire Hathaway doesn’t pay a dividend but Buffett loves dividends. Below are excerpts from Berkshire’s 2022 Annual Letter to Shareholders, which drives home the importance of dividends and long-term investing.
Over the long-term, stocks have a nominal return of about 10% and about 30-40% of the total return in equities have been derived by dividends, so don’t dismiss the importance of dividends over time.
4. Limiting Major Downside Volatility
Volatility is an inherent part of the stock market, but its adverse effects can have an effect on compounding. Employing stop-losses, implementing trend following or incorporating non-correlated assets like managed funds (our talk with Andrew Beer about his managed funds ETF) can help investors avoid the worst of major market declines but those come with a cost as well in that there will be periods when the market is moving higher and those techniques or asset classes are flat or down. But that might be a reasonable price to pay if you are the type of investor who makes bad decisions in difficult markets.
Here is an example of why big downside volatility hurts: Say you buy a stock for $100, which then decreases by 50% to $50. To return to its original value of $100, the stock price needs to increase by 100% to achieve a total return of 0%.
Staying diversified and trying to avoid these types of major losses are what can help investors stay in the game and get the most out of power of compounding.
5. Minimizing the Cash Drag
Cash drag occurs when a significant portion of your investment portfolio sits idle as cash. While some cash allocation is necessary for liquidity and emergencies, excessive cash holdings can hinder the power of compounding. Ben Carlson, popular blogger and member of Ritholtz Wealth, had a post recently on market timing, which is one major reason investors may have a cash drag. His point: have a long-term plan and stick to it. Investors that do that will have a much better compounding runway vs. those that don’t.
6. Being Smart About Taxes
Taxes can significantly impact your investment returns. Understanding and strategically managing tax implications is vital to maximizing compounding’s potential. Consider tax-efficient investment vehicles like ETFs, 401(k)s, or IRAs. Additionally, being mindful of capital gains taxes and adopting tax-loss harvesting strategies can help minimize the tax burden, leaving more funds to compound. Jack Forehand, Matt Zeigler and I discussed a lot of this in the “The Importance of Asset Location” episode.
7. Taking Advantage of Free Money
I work for a small asset management company and we don’t have a formal company 401K plan, but my wife works for a much larger healthcare company and for a number of years she worked for the State of Connecticut. In both of those jobs, her employers offered 401K plans with matching contributions at various levels, a very nice benefit and incentive. This is effectively free money on top of what she is already contributing to her retirement savings. If your employer offers a 401(k) or similar retirement plan with a matching contribution, take advantage of this “free money.” Employer matches are essentially an immediate return on your investment and provide an extra boost to your compounding efforts. Failing to maximize these contributions is akin to leaving potential growth on the table.
8. Dollar Cost Averaging
Dollar cost averaging (DCA) is a powerful technique that involves investing a fixed amount at regular intervals, regardless of market conditions. DCA reduces the impact of market volatility, helps you avoid emotional decision-making, and ensures that you continuously invest. Think about in the context of the past two and half years. An investor who added one dollar into the market every six months starting in 2021 would show gains based on where the S&P 500 is today (4,554). The $5 invested in total would be worth about $5.50 today, and that’s in a period (i.e., 2022) when stocks were down into bear market like territory.
Dollar cost averaging means you are buying consistently, in both up and down markets, but since stocks go up over time this a great way to take advantage of compounding over time.
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Plant The Seeds & Let the Flowers Bloom
Just like in investing, taking a diversified approach to how you think, and take advantage of, compounding is the best approach for most people. As Buffett says above, let flowers bloom but remember you have to start with the smallest seeds of investment. Start early, make the best decisions you can, and stay committed to your long-term goals, and let compounding to be the steadfast hero that works.