Lesson #25: Go Compound!
In his 1962 letter to investors, Buffett carried a section called the “Joys of Compounding”, which was repeated with slight variations in a few more of his future letters (1964, 1965, 1966). He writes …
[when it comes to compounding your money at a decent rate]…relatively small differences in rates add up to very significant sums over a period of years.
Investment decisions should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.
There are financial advantages of:
(1) A long life
(2) A high compound rate
(3) A combination of both (especially recommended by this author)
To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.
In short, dear friend, every extra percentage of returns count a lot when you are compounding money over 10, 20, or 30 years.
In the 1966 letter, Buffett did an about-turn as far his headline for the portion on compounding was concerned.
From “joys of compounding”, it became “sorrows of compounding”.
Why sorrow? Well, read what Buffett had to say…
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.
…I now feel that we are much closer to the point where increased size may prove disadvantageous.
…as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results.
What Buffett was effectively saying was that the large amount of money he was managing by now was getting to be a deterrent for him, given the difficulties in compounding large amount of money.
As an example, at a market cap of around Rs 200,000 crore, it would be difficult for Infosys to double its shareholders money in the next few years. But at a market cap of just Rs 2,000 crore, a NIIT Tech like company can double or treble in a much faster time. (Sorry, but this is not a recommendation!)
In the same way, it’s much easier for your to grow your money at 15-18% compounded over the next 10 years than it is for your mutual fund manager, who is looking after (or may be, managing) thousands of crore of funds.
This is one reason it’s a big myth that “smart” people managing large amount of money can earn you much greater returns than you yourself can.
Of course you need to have the right process and discipline to compound your money at a decent rate.
“What’s a decent rate?” You may ask.
Though stocks have historically been the highest-return asset class, this still means returns in the 15-20% range. Aiming a 20-25% returns per year for a long time is going to be difficult. Remember that’s the kind of return which Buffett has generated and there is only one Warren Buffett. So expecting a long term return in excess of 4-5% over the inflation (or over the risk free return from bank deposits) can be considered decent and reasonable for a small investor like us.
And don’t forget that unless you unlock the secret to time-travel, you will never escape the inherent unpredictability of the future. his is why it is key to always have a margin of safety built in to any stock purchase you may make.
Remember that successful investing is more about having the proper temperament than it is about having exceptional intelligence. If you can keep your head while everyone else is losing theirs, you will be well ahead of the game – able to buy at the bottom, and sell at the top.
With these words, we have come to the end of this course. I hope you found this course worth your time and effort.
I wish you all the best as you move forward in building wealth for yourself, slowly and gradually.