By Rupert Hargreaves. Originally published at ValueWalk.
The Power Of Compounding is probably the most important and lucrative tool in every investors’ arsenal. Warren Buffett understood the power of compounding from an early age and throughout his entire career being, compounding at an attractive rate has been the primary objective over everything else (buffet will only invest if the downside is minimal/non-existent and there is a large potential return available in the bull case in order to maximize compounding potential.)
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Buffett’s desire to compound is immortalized in his first two rules of investing, “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
The Power Of Compounding – Lessons from the Oracle
As noted above, throughout his career Buffett has always worshiped the power of compounding, and he repeatedly extolled the virtues of compounding within the pages of his early letters to partners.
“I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed; the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.” – Warren Buffett letter to partners, January 1963
Buffett has gained a reputation for quotes like the one above, which show quite clearly just how powerful compounding can be, even though the purchase of an entire country is an entirely unrealistic goal for the average investor. The example still gets the point across clearly.
“Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 écus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the écu 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment. However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.” – Warren Buffett letter to partners, January 1964
If you can achieve an attractive return on your money every year and keep losses to a minimum, time will do the hard work for you. The key is not to rush and keep at it for years or decades. In the words of Graham’s assistant Walter Schloss and Peter Cundill:
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“Remember the power of compounding. You don’t need to stretch for returns to grow your capital over the course of your life.” – Walter Schloss
All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering” – Peter Cundill
Of course, if you can’t find investments that make a steady, attractive return, compounding won’t be much use to you. What’s more, if you do find a good investment it’s more than likely that you will sell out during the period of stress, rather than ride it all the way (how many shareholders have held Amazon.com since its inception?).
This is where understanding the power of compounding helps. If you know, as Buffett does and has consistently drummed into his investors since the beginning, that the best way to achieve outsized returns is to compound, then the likelihood of you staying for the ride is high, even though the temptation to sell at certain points might be too much to resist:
“One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit, in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12.5 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6.5% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6.5%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.” – Warren Buffett letter to partners January 1965
Unfortunately, even though compounding is a hugely powerful tool, it has one major downside: it’s too good. Eventually, the power of compounding will give the best investors so much capital replicating prior success becomes an issue. It’s at this point where compounding is no longer a useful tool, instead, it can become a hindrance.
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“The Sorrows of Compounding. Usually, at this point in my letter, I have paused to modestly attempt to set straight the historical errors of the last four or five hundred years. While it might seem difficult to accomplish this in only a few paragraphs a year, I feel I have done my share to reshape world opinion on Columbus, Isabella, Francis I, Peter Minuit and the Manhattan Indians. A byproduct of this endeavor has been to demonstrate the overwhelming power of compound interest. To insure reader attention I have titled these essays ‘The Joys of Compounding.’ The sharp-eyed may notice a slight change this year.
“A decent rate (better we have an indecent rate) of compound plus the addition of substantial new money has brought our beginning capital this year to $43,645,000. Several times in the past I have raised the question whether increasing amounts of capital would harm our investment performance. Each time
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