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Let compounding work its magic

If you haven’t read Morgan Housel’s Psychology of Money yet, I thoroughly recommend that you do. This book offers a superb examination of human behaviour, neatly packaged into 19 short stories exploring the odd ways we think about money. 

What’s stuck with me most is his assessment of risk. He explains that the right price of an asset for one person might not be the right price for someone else. Thinking that stocks have one rational price is a financial idea which has done “incalculable damage”. 

Certain stocks are flooded with day traders. But the right price of a stock for a trader is entirely different from the right price of a stock for an investor, which is why bubbles occur.

Take the dotcom boom as an extreme example. In the late 1990s, Cisco (US:CSCO) rose 300 per cent in a year so a short-term trader would have been justified in buying it. But Housel says economist Burton Malkiel once pointed out that Cisco’s implied growth rate at its peak $550bn (£396.27bn) valuation meant it would have become larger than the entire US economy within 20 years – which is insane. So when you invest, bear in mind that the price of an asset may be set by someone with very different goals to you. This is why it's critical to do your own research and make sure that you're happy the price you are paying is right for you. As anyone who has dabbled in bitcoin recently is well aware, sentiment driven assets can fall very quickly when the market mood changes.

It can be difficult to avoid jumping on the bandwagon of rising asset prices, and people can make a lot of money quickly out of doing it. But it’s a risky strategy. The odds are that it won’t make you richer in the longer term, and it’s definitely not a robust way to build a financial plan.  

The most powerful force for wealth creation, for most people, is time. We often write about the power of compounding interest, but it is still one of investing’s most under appreciated truths. After all, linear thinking comes more easily than exponential thinking. 

“Counter-intuitiveness of compounding may be responsible for the majority of disappointing trades, bad strategies and unsuccessful investing attempts,” asserts Housel. Devoting all your time to trying to get the best stock market returns may seem like the best way to get rich. But your financial plan should not be about trying to get the best investment returns, as higher returns usually come with higher risk and prove unsustainable over time. You should aim to make good returns that are sustainable over a long period of time, and let compounding work its magic. 

 

 

Warren Buffett is a glorious example of this and the key to his success has been time. He bought his first stock 75 years ago, aged 11, and Housel says that he had $1m by the time he was 30 and $200m by the time he was 50. Buffett is now worth around $100bn and Forbes calculates that he’d be worth almost twice that if he hadn’t given away wealth to philanthropic causes since 2006. 

But to aspire to be Buffett is to set yourself up for disappointment. Rather, we should keep a close eye on what we can realistically hope to achieve, with compounding in mind. If you plan to hold your investments for decades, a recession next year is unlikely to make a difference to your investment plan.