Long Term Investing and the “Magic” of Compounding

Long Term Investing and the “Magic” of Compounding

At Outcome Wealth Management, we often say that investing is largely about harnessing the “magic” of compounding. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” The Sage of Omaha, Warren Buffet, set a very explicit goal at an early point in his investment career: to compound capital at the best possible rate
over the very long term.

It’s What You Don’t Do That Has the Largest Impact on Long-Term Performance:
With respect to the pursuit of his objective, Buffett clearly understands that losses hurt far more than
gains help. It is very difficult to recuperate from large losses, and such declines devastate investors’ rate
of compounding and their long-term returns. This observation is summarized in Buffet’s two rules of
investing:
1. Don’t lose money.
2. Don’t forget rule number one.
The table below demonstrates the subsequent gains that are required to recover from declines of
different magnitudes:
Initial Loss Subsequent Gain Required to Recover Loss
- 10% +11%
-20% +25%
-30% +43%
-40% +68%
-50% +100%
The Path Affects the Destination:
The path of one’s returns has a significant impact on long-term performance. Two investments with
identical, arithmetic average returns can produce significantly different compounded returns over time
depending on their differing degrees on volatility. All else being equal, lower volatility investments have
significantly higher long-term returns than higher volatility investments.
As an example, the following chart illustrates two investment managers that produce identical,
arithmetic average returns of 5% over a 30-year period. The lower volatility manager’s returns are less
extreme, rising less in strong markets and falling less in down markets. Conversely, the higher volatility
manager’s returns that are more extreme, rising more in up markets and falling more precipitously in
down markets.
May 2018 Commentary
The following graph illustrates that, despite having the same arithmetic average return as the higher volatility manager, the lower volatility manager produces significantly higher compounded returns over the long term. This observation clearly indicates that managing volatility and mitigating losses in bear markets is an essential element of successful long-term investing.
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Return
Year
Two Managers: Same Average Returns & Different Volatilities
Lower Volatility Manager (Average Return = 5%)
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
35,000,000
40,000,000
45,000,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Value of $10 Million Investment
Year
Two Manages: Same Average Returns & Differet Volatilities: $10MM
Investment
Lower Volatility Manager Higher Volatility Manager
Lower Volatility Manager
Average Return = 5%
Higher Volatility Manager
Average Return = 5%
Portfolio Value = $31,729,594
May 2018 Commentary
Tactical Asset Allocation: The Most Effective Way to Mitigate Losses in Bear Markets:
When it comes to protecting capital in bear markets, the truth is that picking “good” stocks can only get
investors so far. In late 2008/early 2009, it didn’t matter which stocks you owned – nearly all stocks
suffered precipitous declines. The only way to avoid large losses was to not own stocks (or at least have
a small allocation to stocks). It is the markets you choose (and when) rather than the securities you
choose that ultimately defines your long-term returns. In other words, asset allocation handily trumps
security selection in terms of their respective influences on investors’ performance over the long-term.
At Outcome Wealth Management, we focus exclusively on asset allocation to maximize long-term
performance by participating in rising markets while simultaneously avoiding large losses during bear
markets. To this end, we have and will continue to achieve this objective by following our systematic
process based on quantifiable evidence.