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Wit, Wisdom, Warren (Issue #7): The Joys of Compounding

Last time, I reviewed lessons from Warren Buffett’s 1961 letter to partners of Buffett Partnership, with a special focus on how Buffett invested his money across different kind of investment categories.

Today, I review his 1962 letter, with a special focus on “compounding”.

The Joys of Compounding
In the 1962 letter, Buffett carried a note about the annual performance of some of the biggest investment companies then over the previous six years (1957-1962), and how none of these were able to beat the Dow.


He ascribed two reasons for the underperformance of such companies. One was their size. He wrote, “Within their institutional framework and handling the many billions of dollars involved, I consider such average results virtually the only possible ones.”

As for the second reason, it was that while these firms were doing a service to millions of investors in achieving adequate diversification, providing convenience and peace of mind, etc., “…their services did not include the compounding of money at a rate greater than that achieved by the general market.”

In other words, these investment firms were not built on the framework of compounding money. Like a large majority of today’s mutual funds, these were just “fund accumulation agencies”.

As for Buffett’s Partnership, compounding was at the heart of its investment philosophy. This is what Buffett wrote…

Our partnership’s fundamental reason for existence is to compound funds at a better-than-average rate with less exposure to long-term loss of capital than the above investment media.

We certainly cannot represent that we will achieve this goal. We can and do say that if we don’t achieve this goal over any reasonable period excluding an extensive speculative boom, we will cease operation.

Buffett carried a section called the “Joys of Compounding” in the 1962 letter, which was repeated with slight variations in a few more of his future letters (1964, 1965, 1966).

Most of these variations across the years were on account of real-life examples Buffett gave in order to drive home the point on compounding. Here are the three he talked about.

In his 1962 letter, Buffett shared the story of Queen Isabella of Spain sponsoring Christopher Columbus’s voyage in 1492 to find a “new world” at a cost of around US$ 30,000. Buffett called it a low-compound investment, as the same money invested at 4% compounded annually would have amounted to something like US$ 2 trillion by 1962 (or 470 years later).

Then, in the 1964 letter, he wrote…

Francis I of France paid 4,000 ecus (European Currency Units) 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 ecu 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.

Finally, in 1965 letter, he wrote…

…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 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return to obtain the last laugh on Minuit. At 6 1/2%, $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.

After reading this, you may wonder, “All this sounds fanciful. Who lives 300-400 years to benefit from such compounding?”

Well, Buffett would answer you this way…

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.

[But 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 tribesman, every extra percentage of returns count a lot when you are compounding money over 10, 20, or 30 years.


The Sorrows of Compounding
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.

…there have been a few times in the past when on a very short-term basis I have felt it would have been advantageous to be smaller but substantially more times when the converse was true.

Nevertheless, 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 137,000 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 530 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.

Anyways, here are some numbers I share with youngsters (younger than me :-)) whenever I talk to them about the importance of saving and investing.

The way is to not tell them directly the importance of investing money, but to tell them the importance of avoiding wasteful expenses and what they can get when they do so.

Like if they save just Rs 50 per day, or Rs 1500 per month, by avoiding a Cappuccino at CCD, and invest that money at 15% annual returns, here is what they can get…

  • Rs 42,000 in 2 years, or enough money for the latest 4G mobile handset
  • Rs 133,000 in 5 years, or enough money for a small foreign holiday
  • Rs 412,000 in 10 years, or enough money to buy a small car
  • Rs 22,45,000 in 20 years, or enough money to part-fund a house

All one needs to do is save Rs 50 per day, invest it sensibly, and then let the power of compounding work its magic.

If there’s one lesson that young investors can take from all of Buffett’s letters over the past six decades, this is it.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Anil Kumar Tulsiram says:

    Hi Vishal

    Thanks for another excellent post. The moment I saw the table under Joy of compounding, I was reminded of Seth Klarman who always insist on not losing money and how it greatly enhances the benefit of compounding. Here are the extract from his book, Margin of safety.

    “Compounding works in your favour if you never loose money: A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

    It should be the single most important objective of any investor. A investor who earns 16% pa for 10 years and another who earns 20% for nine years but losses 15% in tenth year, A will be better off. If investors focus on rate of return focus will be on upside and not on avoidance of loss. Benchmark rate of return should be risk free rate of return and one should invest in risky rate of return if risk reward ratio is favorable. Future is unpredictable, so be prepared for the worst event, even if they occur once in a century.”

    • Brilliant observation…this is one of the many superb ideas from “Margin of Safety” that is worth millions of dollars. Thanks for reminding us again.

    • Thanks for sharing this amazing thought, Anil!

      This reminds me of what Munger says so often, “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”

  2. Compounding is indeed the 8th wonder.
    Keep saving keep investing.
    I will try and locate and send across an article in which a teacher of finance is asked what is the way/ rule of investing.
    He replied ‘dont lose’ (as in lose any principal amount) and that ‘investing is like a marathon’. A marathon because if you notice even the guy who comes last raises his hands in joy when he crosses the finishing line. What he means is that each one of us have financial goals or set of goals and our investment style and method should help us get to our finishing line(s).

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