The magic of compounding
Go invest,
young man
Not long ago I was having dinner
with a couple of friends. Their son was there too. He is studying business and
administration in a top European university. So when I was asked by this young "millennial", where to start learning about investing and when he should start
investing, I said study Buffet and start as early as you can!
Paraphrasing John Babsone Lane
Soul (popularised by journalist Horace Greeley) with his famous „Go West, young man, and grow up with the country“ my advice was simply „go invest, young man, always invest and grow up with the market“.
Study the
Snowball
The reference to Warren Buffet is
self explanatory. His financial success embodies the magic of compounding and
the significant riches that lie ahead for those ready to commit to a lifetime a
disciplined saving and investing.
Buffet‘s letters to shareholders
are a must read too for every student of the markets. In the last one, he is
discussing the simple compounding merits of steady investing into low cost index tracker funds. In
theory, these would enable investors to replicate most of the long term returns
of the S&P500, arguably the most efficient portfolio in the universe.
On page 2 of his annual letter, there is a table detailing the growth of Berkshire Hathaway’s book value per share versus the return of the S&P500 for any given year since 1965. It shows what would have been the equivalent performance of owning the S&P500 with all the dividends reinvested on tax free basis.
From 1965 to 2017 and despite many ups and downs, many crises, the total cumulated appreciation of the S&P500 stands at 9.9%, of which c.6.8% is the average return of the index itself and c.3% is the dividend portion.
The magic
of compounding
Had my friends invested on the day of their son‘s birth (I guess somewhere around 1997) and bought an S&P500 tracker ignoring transaction costs and assuming the same theoretical tax free reinvestment of dividends, they would have achieved broadly the same 10% a year and this despite two major bear markets (declines of more than 20%) and many corrections (declines of 10% or more) in between.
An initial USD 10k investment at their son's birth would be worth USD 67k in 2017. The same 10k, if left compounding alone at this rate of 10% and untouched until their son's sixtiest birthday, would transform this initial USD 10k into USD 3m, a very nice retirement pot by any measure and a very nice birthday present indeed (USD 3m would give you at 2.4% some USD 72K of annual gross income).
This magic of compounding was once called the eighth wonder of the universe and the most powerful force in the universe by Albert Einstein.
A 10% post tax return would double your capital in 7.2 years, but 15% would do the same in less than 5 years. Buffet, with his 20% has done it every 3.6 years. The rule of 72 described below by the grand master himself summarising the principle.
Clearly, compounding is a matter of speed, a function of average returns and time. Like in the tortoise and the hare story, the important is not to start fast (everyone can have a lucky streak, especially the beginners), but to go the distance.
Have money
work for you instead of working for money
Buffet uses the market instead of
being used by it. He has made money working for him instead of having to work
for money.
As shown in Appendix, you can earn a good salary all your life, which will help you cover your costs and inflation, have a comfortable life and even save some decent money over time. But in terms of building wealth, nothing compares with stocks and understanding that investing early in the S&P500 is the key to achieving wealth over the long term.
Grow with
the market
The S&P500 is one of the most efficient
portfolios there is. The index automatically rebalances towards the
best performing stocks, while the underperformers are dropped from the list
regularly thereby keeping the list focused on the best corporate earnings
streams America has to offer.
Since 1965, the S&P 500
index has removed on average 22 companies each year or 4.4% of the index. The
changes have been less pronounced since 2013, but still some 10% of the
S&P500 are were not in the index in 2013. The gap is more than half when
compared to 1999.
Estimates vary, but this called
the „survival bias“ tends to flatter the performance of the index by 0.3% and
1% a year and one of major reasons (on
top of fees and other administrative and transactional frictions) the majority
of investors cannot outperform the S&P500 index and why passive investing
has grown in popularity over the years.
Another flattering factor is the
so-called „money illusion“. The S&P500 is a key recipient of money flows. When
the Fed’s printing press is active, the dollars in excess of the growth of the
economy tend to look for a home and tend to increase the PE (price/earnings
ratio) of the index. When the dollars finally decides to exit banks‘ coffers and
get back in the economy, they do lift corporate earnings and the replacement
costs of certain property, which do offer a certain „edge“ against inflation.
This is illustrated by the
Shiller-Yale monthly index update (which can be downloaded from the
university’s website for study), such that the „real“ performance of the
S&P500 over the period equals to 7% rather than 10%, still well ahead of treasuries.
If inflation is the same as it has been since my friend's son's birth in 1997 or 2.2%, then his USD 72k income would be equivalent to something close to USD30k in today’s money, not exactly a full average wage but not bad.
The majority of investors (even professional ones) fail to outperform the S&P500 after fees and other frictions over time.
Transactional costs are the main factor behind this underperformance, but other behavioural factors such as not having enough cash to invest when needed the most are the other pitfalls of the active investors.
The
best investors (including Buffet) do it by a margin of c.5-10% per annum and
sometime more with the right amount of conviction and leverage (Soros, Simons,
Druckenmiller etc.). But these are the exception rather than the rule.
What separates the average investor from the good
ones and the good from the great are only a few percentage points.
Yet, doing consistently and over many years requires great skill, not just doing the right thing (investment philosophy/method/processes), but doing things right (disciplined execution). These small differences are not complicated in theory, but are not easy in practice (if it was easy everybody would be rich, so that everything would cost a lot more). Accumulated year after year, these few extra percentages over the S&P500 compound to very large difference over time indeed.
In that regards, the reinvested dividend portion
thing is important. After all, since 1965, this process produced almost a third of the
returns over the period. At the end of 2017, dividend yield was a meagre 1.8%
and the Shiller cyclically adjusted PE stood at historic highs, a healthy
warning that things change and fluctuate that future returns may not replicate
those of the past.
For example,
inflation may reaccelerate, but interest rates may also rise, which means that
the same multiplier effects might not be seen or might even reverse (see Appendix).
That said over time, even if the PE of the S&P may fluctuate and react negatively to rising interest rates or deflationary conditions for example, the regression to the 10% average seems embedded in the average ROE of the S&P500 over the period and the performance of the index be a function of retained earnings.
Buffet outperformance as an active-passive investor consists in leveraging a portfolio of S&P500 stocks bought at reasonable PE of well capitalised companies displaying above average (generally above 15% ROE) and sustainable return of capital protected by sustainable competitive advantages and run by competent management capable of redeploying their excess earnings at profitable rates over a long period of time.
Who wants
to be a billionaire?
A study of billionaires over the
ages is a good illustration of that point. The first billionaire in USD was
John D Rockefeller in 1916. Fast forward in 1982, when the first Forbes
400 rich list was published, there were „only“ 13 billionaires on the list,
while USD 75m (USD 196m in today’s dollar, i.e adjusted for inflation) of
personal fortune was enough to get you a slot on that prestigious list. Today,
all of the members of America’s 400 richest list are billionaires and the
minimum ticket is a cool USD 2bn (26.7x more than than in 1982), while the
total number of US billionaires is estimated at 560 or 43x more than in 1982.
This billionaires‘ „epidemic“ is
a worldwide phenomenon. In 2017, the magasine estimated that there were 2,043 of those plutocrats in 2017 with a cumulated fortune
of USD 7.71tn or USD 3.77bn on average per billionaires, Bill Gates still
leading the league table then with a personal fortune estimated at USD 89bn. He
has now been overtaken by Jeff Bezos, while the number of billionaires could be
2208 with a cumulated wealth of USD 9.1tn, a reminder that the list fluctuates but continues to
grow. It actually more than doubled since 2010, not necessarily a surprise
considering the performance of the world stock market over the same period.
Over the 1982 to 2017, the S&P500 grew by 21.5x (including 7,2x due to earnings and 3x due to PE expansion) so within the same
proportion as our US billionaires’ growth story, but considerably outperforming the
economy (GDP/capita grew by 3.7x over the period), average wages (3.2x over the
same period), Gold (3.1x), house prices (2.9x) or inflation (2.6x).
To the dismay of Thomas Picketty, the gap between income and capital
growth is widening the gap between rich and poor, even if the optimist would notice that the majority grows richer over time. Yet, the gap is nothing new.
Vilfredo Pareto, then professor at the university of Lausanne, published in
1906 his seminal work on income disparity, discovering a power law, now known
as the 80/20 rule.
This states that any given population, 80% of the income is
achieved by 20% of the population, leaving 20% to the rest. Imagine a system
where amount of money does not change and where all participants start with the
same portion of capital and bet a constant portion of capital with a fifty
fifty chance of winning and losing that bet. Soon enough a group would have won
the longest series would end up with a
disproportionate share of the pot, while large portion of the population
would end up with no capital.
We are 7.6bn people in the world today, while the total value of
personal wealth according to the world bank totals USD 202 tn (2.5x global GDP) of
which 40% was non investable and 60% investable. If one were to apply the
Pareto 80/20 rule, one would find out that 50% of that wealth would belong to
the famous 1% (0.8% to be precise), while 0.0001% would control c.11% of the
pot.
These shares can also be found in
the Cap Gemini wealth survey, the latest one estimating the number of USD
millionaires at c.16.4m (0.2% of the world’s population) and controlling USD
63tn of wealth (31%) of the total. Of these
millionaires, 90% are „millionaires
next door“ with assets of USD 1-5m, 9% are High Net Worth Individuals (HNWI)
with assets between USD 5-30m and 1% are the so-called Ultra High Net Worth
Individuals, those with assets exceeding USD 30m. The UBS wealth survey would
go one step deeper into the split of these UHNWI, but you get the point.
A billionaire would only have to
put his billion in a 2.4% one year treasury bill to earn risk free in one year
more money than the personal wealth of 99.99998% of the world’s population.
This type of wealth goes well beyond a life of luxury, it is plainly speaking
true power.
So young man, from the day you
are born to today you are (according to the Pareto law), one degree of
separation to the middle class, four degrees of separation from a life of
affordable luxury, six degrees from a life of luxury and ten degrees to true billionaire power. The choice is yours.
If ever you decide you want to be one of those
2200 few billionaires, you have actually four options:
· You can be very lucky. The
lucky ones are those who inherited or married a great fortune, cronies or other
fellows who happened to be at the right place at the right time or took
extraordinary risks that paid off big.
· You can also have a great
idea and have the courage to make a reality and change the world, by becoming
one the great entrepreneurs, also called the dreamers. The would mean join the
Bezos, the Gates, the Brin and Page of this world, people who invented new ways
of doing thing and selling products or services that we all use.
· Otherwise, you can focus
on your talent at captivating attention, at leading the crowd, become a sporting
legend, a TV or movie star, or a CEO, or any other profession where your
extraordinary talent can allow you to command extraordinary rewards.
· Last but not least, you
can belong to the less glamourous camp of savers and investors. These are
generally the old tortoises of the list, the Buffets, the Druckenmillers and
Soros who either had the money when nobody else had it were able to capitalise
on their insight, conviction and power of compounding and financial leverage. Unless you have extraordinary talent or have a genius idea
that will revolutionise the world, your best shot at reaching billionaire
status lies in this category.
|
- those who own one great
company and stick to it for the long run
Dreamers/Inventors
|
- those who have money
when others need it (Buffet, Frere, Slim)
Savers/Investors
|
|
- those who are at the
right place at the right time (sector, inheritance)
Lucky ones
|
- great men (inventors,
dictators, artists, geniuses, entrepreneurs, etc)
Dreamers
|
What separates a USD 26.5k
average wealth per capita of the average human from the USD 4bn of the average
billionaire is a return of 35% over 40 years, 27% over fifty and 22% over 60
years and 19% over 70 years.
If your ambition is for UNWHI, USD 30m would do,
then 19% over 40 years, 15% over 50 years, and 12% over 60 year will be enough.
HNWI status would only require you to put some money aside every year, buy the
S&P500, reinvest the dividends systematically in a tax free and low cost
manner and let the magic of compounding do the rest.
In Switzerland, one of the world's wealthiest country per capita, there were 28 billionaires in 2015 (1/286000), 590 with more than USD 100m (1/13550), 5700 with more than 30m (1/1500 people), 18200 with more than 10m (1/439) and 343k with more than 1m (1/23). You now know your odds.
Death, tax and other matters
Reaching the list is one thing,
but staying in it seems to be even harder. In 2012, some thirty years after the
first Forbes 400 rich list was first released, only 36 members of the original
list or less than 10% were still on it. Nothing is so enduring as change.
We would ignore the tax for now,
but death is worth taking into consideration.
Average life expectancy is 78.74
in the US and 83.2 years if you live in Switzerland. If you happen to reach 80,
you might have another 9 years to go on average. If you stretch to 85, then 91.
In Switzerland, some 1500 hundred years old plus, the majority of those being
women. So it concerns 0.02% of the population and therefore it might not be a
good bet to base your financial plan on such a long life. It could be a boring
too. So improving your return prospects and trying to beat the S&P500 by a
few percentage points every year is probably a better option.
Death, tax, over leverage, over concentration,
over spending, family disputes (including divorces) are the main pitfalls that
have led to this high turnover, but not only.
The original list was dominated
by oil magnates (inspiring in the process the popular TV series Dallas) as well
as industrialists. Today, the list is populated by „tech“ entrepreneurs,
consumer goods empires or financiers. So, on your way to billionaire status,
make sure you get your tax in order, live a healthy life and marry well.
The other lesson of that list is
that the speed at which millionaires reach billionaires status is not a straight line. It fluctuates.
Dream your
life and live your dream
So, young man, if you want to be rich, do not bet on your salary but on the magic of compounding.
Starting early will give you an edge, especially as costly mistakes should be
done early in life. Study the masters, stay curious, keep the course and accumulate.
Appendix
| 1982 | 2017 | Multiplier | CAGR | |
| Billionaires in the USA | 13 | 560 | 43.1 | 11.4% |
| Forbes min ticket (USD million) | 75 | 2000 | 26.7 | 9.8% |
| CPI | 94 | 247 | 2.6 | 2.8% |
| 10 year bond yield (%) | 0.1459 | 0.024 | 16% | -5.0% |
| 1/10year yield | 6.9 | 41.7 | 6.1 | 5.3% |
| S&P500 | 123.8 | 2664.34 | 21.5 | 9.2% |
| EPS | 15.2 | 109.9 | 7.2 | 5.8% |
| PE | 8.2 | 24.2 | 3.0 | 3.2% |
| Earnings yield | 12.3% | 4.1% | 0.3 | -3.1% |
| Cyclically adjusted PE | 7.39 | 32.09 | 4.3 | 4.3% |
| Cyclically adjusted earnings yield | 13.5% | 3.1% | 23% | -4.1% |
| Gold | 400 | 1240 | 3.1 | 3.3% |
| GDP (USD tn) | 3.3 | 19.4 | 5.9 | 5.2% |
| GDP/capita (USD) | 14400 | 53128 | 3.7 | 3.8% |
| Average wage (USD per annum) | 13773 | 44564 | 3.2 | 3.4% |
| Income of the "1%" (USD) | 220,000 | 481000 | 2.2 | 2.3% |
| Multiplier of average | 16.0 | 10.8 | ||
| Average US house price | 66200 | 188900 | 2.9 | 3.0% |
| Home price / income | 4.8 | 4.2 | 0.9 | |
| Oil price | 31.83 | 42.63 | 1.3 | 0.8% |
| UK house | 45211 | 272000 | 6.0 | 5.3% |
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