Macro Minute: Week of November 18, 2024
Over the past three weeks I have been covering some general investing topics. Liquidity, micro and macro trends, and portfolio construction are great and all, but what is the point of doing this. Put simply, it is all about the compounding. The whole point of investing is to compound your capital at a greater rate than inflation destroys it. Albert Einstein called compounding the 8th wonder of the world. In thinking about compounding, it is important to understand several factors. Today I want to cover time, absolute and real return, and touch on some behavioral biases that can prevent us from reaching our highest compounding potential.
“Time the past has come and gone
The future’s far away
And now only lasts for one second”
The above lyric from Hootie and The Blowfish illustrates well, we only have this moment that we live in but we know our past and we shape our future. When thinking about time in the context of compounding, it is all about how long you can do it. If you can compound your capital for a long amount of time, those later years can have a profound impact on the value of your capital. For example, Warren Buffett to me is a great investor not because of the high returns he generated over his lifetime but because he has done it for so long. 99% of his net worth has been generated after he turned 65 years old. Think about it, after the age of retirement for most people he accumulated the majority of his wealth. This is a great example of how once you start compounding you should let it continue for as long as possible. If I were to send out invites for a compounding party, I would tell you to come early and stay late. The longer you stay at the party, the better off you will be.
Now let’s talk about what everyone loves to brag about, investment returns. Returns are important, but they need to be framed appropriately. Above I mentioned the terms absolute and real. I added absolute because you must account for all the factors on that return. People like to brag about what a return on a specific investment over a specific time period achieved. That is not really helpful a lot of the time. We must look at it over the whole time and within the complete portfolio. When analyzing compounding, we want to look at the whole picture for the complete time, including any tax drags. Let’s say you have a portfolio that you have invested for 20 years. You want to make sure you are looking at that return over the entire 20-year period, not just the best one or two years. Sometimes the better investment over the long term is not necessarily the investment with the highest return, but the one that has limited down periods. Let’s look at two portfolios over a 5-year period with the same average return, but differing paths.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Conclusion | |
| Portfolio A | 20% | -15% | 10% | -8% | 20% | Average 5.4% a year |
| $10,000 | $12,000 | $10,200 | $11,220 | $10,322.4 | $12,386 | Less Money |
| Portfolio B | 10% | 5% | -3% | 7% | 8% | Average 5.4% a year |
| $10,000 | $11,000 | $11,550 | $11,203.5 | $11.987.75 | $12,946.76 | More Money |
As the above example shows, you can achieve better results over time by compounding more consistently, even if you have lower returns on a short time frame. The other word I used was real. This is a finance and economic term that just means “after inflation”. For example, if you had a return of 10% and over the same time period inflation was 4%, the real return would be 6%. Remember, our goal of compounding is to outpace inflation over a long period of time.
To this point we can probably all agree that this sounds easy in principle. Come early and stay late to the compounding party and look for consistency with your returns. But let’s talk about some behavioral biases that psychologists have identified that make this simple solution hard to execute.
Let’s start with social comparison bias. It is the idea that individuals determine their own worth based on how they compare to others. Can we all agree we have a society built around this one? We are marketed to constantly wanting us to get the latest this or that because a celebrity or social media influencer uses it. This is why when our neighbor gets a new car, we feel the need to get one too. A coworker goes on a luxury vacation, and suddenly we feel like we have to go on one even though we hate the sand. This explains how most quantifiable measures of real wages and household net worth are up many times from previous decades, yet the surveys continue to be weak. The “I am ok but the world is going to crap” mentality is a hard one to break. The reality tells us that by and large, people in the U.S. are doing pretty good. The biggest thing about social comparison to me is how it helps explain that we constantly move the goal post as we accumulate more. As society has gotten wealthier, we compare ourselves to an ever-richer culture. The desires people had from the past are now commonplace. We are constantly changing our comparisons and goals. We tell ourselves, as soon as I have a certain amount of money, I will be happy, and as soon as that is met, we change the number. In investing, this makes it hard to be satisfied with a certain return when we see that someone else is getting a higher return. This can lead to chasing performance, and as a result, taking on more risk than we should. We must remember the name of the game is compounding, and those negative periods associated with too much risk have harmful impacts upon our ability for the compounding to continue.
The other bias I will touch on is loss aversion. This is how humans perceive losses as twice painful as the equivalent gain. We hate losses. So much so that we feel the need to have twice as many gains to offset a loss. This can lead people to not take on enough risk in order to avoid losses, because we perceive losses as much worse than they are.
Compounding is what it is all about. It is simple in principle, come early and stay late to the compounding party. The problems occur when we fail to realize the importance of time and the fact that our brains are wired to fight against us. Last week I described how I build portfolios to help me keep a “longview” mindset and help overcome some of these biases. I hope you find it helpful, and find succuss on this compounding journey.
DISCLOSURES:
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