April 9, 2018: Exponential Or Compounding Nature In Investing

Apr 10, 2018 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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Exponential Or Compounding Nature In Investing

We have pondered some astounding facts on arithmetic in investing in some previous newsletters like:

The arithmetic facts are simple enough for people with middle school level education to understand. However, even many sophisticated individuals with much higher education can ignore and misunderstand these in investing. Just as  physicist Albert Bartlett put it: 

“The greatest shortcoming of the human race is our inability to understand the exponential function.”

Let’s look at some of the other interesting facts. 

Loss arithmetic

Some well-known loss arithmetic (see the first newsletter cited above) includes a loss of 50% needs a 100% gain to make it back. However, loss in investments is usually unfolded in a process, not in one fell swoop. In fact, in a typical bear market, the loss can happen in several stages. For example,  

  • 90% loss is first to lose 50% and then another 80%
  • 60% loss is first to lose 20% and then another 50% or 
  • 60% loss is to lose 20%, another 20% and then another 37.8%

The point here is that you might first experience a 20% loss, a common definition of a bear market, only to see the loss accelerates more. What’s more, 50%+80% is much bigger than 90%. Same for 20%+20%+37.8% vs. 60%. 

Put it another way, in a loss situation, compounding works against investors to inflict much bigger pain to incite fear, one of the twin evils in investing. 

On the other hand, assume you are losing 1% a year, do you know how long it will take for you to lose 50%? You would guess less than 50 years, right? Wrong, it actually takes 69 years to do so. Again, we are fooled by the exponential functions. In this case, steady constant loss saves us or slows down the loss process. 

However, if you would only be getting 9% annual return instead of 10% each year, how much worse you would be after 30 years, assuming you start with $100k? 

10%: you would get $1.7 million after 30 years

9%: 1.3 million after 30 years. 

A 30% less from the 9% point of view! On the other hand, if you would only get 8% annual return instead, that’ll be 75% difference!

Fun facts on Buffett’s wealth

We all know that Warren Buffett is one of the wealthiest in the world. To be more precise, he is worth about $81 billion today. But do you know that among this $81 billion, $80.7 billion was accumulated after his 50th birthday! So majority or 99.6% of his wealth was after he was 50 years old. 

Of course, one of the important lessons from Buffett’s wealth accumulation is that he started to invest very early, or when he was 10 years old. By the time he was 30, he already had about $1 million, or $9.3 million in today’s dollar after adjusted for inflation. 

But don’t despair, say if you were a youngster who only started with $10,000 when you were 30, instead of Buffett’s $1 million. Assuming you have his patience and investing prowess and getting the same returns since then. You would have accumulated $810 million today. No bad at all, though you won’t be in the billionaire club. Still compounding works for you, just not as much as if you would start early. 

However, that’s still a 99% difference. Unfortunately, the effect of the late start is permanent. In fact, in June 9, 2014: The Arithmetic of Investment Mistakes newsletter, we illustrated this fact by the example of an investment mistake made just in one year. 

To summarize, the nature of compounding or exponential growth or loss can surprise us. Little things like start early even with little money, minimize mistakes or loss instead of going for bigger gain (thus higher possibility for bigger loss) and year in and year out consistently stick to a plan can go a long way in wealth accumulation and preservation. 

Market Overview

The inability for stocks to recover has increased the possibility of a much greater correction. The following chart shows since February 2nd, this correctional process has drawn out for more than 2 months now: 

The major stock indexes are all languishing since February. Put it another way, the current correction increasingly looks like a top formation process. Currently, investors have a hefty hope on the last quarter’s earnings growth. On the other hand, given the lofty stock valuation and many policy uncertainties such as a trade war with China, the risk is abundant and even some small-scale events can trigger an avalanche of loss. As always, stay the course and manage risk vigilantly. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

Now that the Trump administration has been in the office for more than a year, the economy and financial markets are in general still in a good shape. Whether the economy will continue to benefit from the supposedly trickle down of the tax cut, the deregulation, and the promised infrastructure spending remains to be seen.  On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in. 

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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