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CONFOUNDING COMPOUNDING

by | Feb 1, 2022

“96% of Warren Buffet’s net worth came after his 65th birthday.  Our minds are not built to handle such absurdities.”.    

I was given a book by a good friend and colleague in the industry which I read in the holidays, entitled The Psychology of Money by Morgan Housel which, I believe, we could all profit from.  To open the year, I want to share a lesson from this book which is vastly underappreciated – the subtle power of compounding.

Sound boring?  Let’s take a peek at the history of the ice-ages over billions of years, and what it illustrates to us about accumulating our wealth.

After many a theory about how the Earth evolved over time, it was not until the 19th century that scientists agreed the Earth had, on multiple occasions, been covered in ice – 5 distinct times, to be exact.  In the early 1900s Serbian scientist Milutin Milankovic’s theory assumed the tilt of the Earth’s hemispheres caused voracious winters cold enough to turn the planet into ice.  But a Russian meteorologist named Wladimir Koppen dug deeper into Milankovic’s work and discovered a fascinating nuance – Moderately cool summers, not voraciously cold winters, were the icy culprit.

As Housel demonstrates, it begins when a summer never gets warm enough to melt the previous winter’s snow.  The leftover ice base makes it easier for snow to accumulate the following winter, which increases the odds of snow sticking around in the summer, which attracts even more accumulation the following winter.  Fascinatingly, you begin with a thin layer of snow left over from a cool summer that nobody would so much as question and then, in a geological blink of an eye, the entire Earth is covered in ice so think it spans kilometres.

A lesson from the ice ages is that you don’t need colossal force to create remarkable results.  If something compounds, a small starting base can lead to results so extraordinary they seem to defy common sense.  It can be so logic-defying that you underestimate what’s achievable, where growth comes from and what it can lead to.

And so it is with our money.

Whilst a couple of thousand books are devoted to how Warren Buffet made his wealth, few highlight that whilst he was a remarkable investor, he was a remarkable investor for three quarters of a century!  Had he started investing in his 30s and retired in his 60s, his name would be lost in the sea of humans that roam our planet.

Essentially all of Buffet’s financial success can be attributed to the financial foundation he built in his juvenile years and the longevity of investments he maintained in his senior years.

His skill is investing, but his secret is time.  That’s how compounding works.

Housel reminds us that that whilst Buffet may be the richest investor of all time, he’s certainly not the greatest – not when measured by average annual returns.  As an example, John Simons, head of a US hedge fund, has compounded money at 66% annually since 1988 – Buffet has compounded at roughly 22%, a mere third as much.  Today, Simons’ net worth is around $21 billion; he is 75% less wealthy than Buffet.  Why the difference?  Whilst Simons is a better investor, he only found his investment stride in his early 50s.  He had less than half as many years to compound as Buffet.  If Simons had earned his 66% annual returns for the 70-year span Buffet has assembled his wealth, he would be worth – WAIT FOR IT – “sixty-three quintillion nine hundred quadrillion seven hundred eighty-one trillion seven hundred eighty billion seven hundred forty-eight million one hundred sixty thousand US dollars”!!!

These are preposterous, unrealistic numbers. What seems like insignificant changes in growth assumptions can lead to such apparent absurdities.  And so, when we are studying why something got to become as potent as it has – why an ice age formed, or why Buffet is so wealthy – we tend to overlook the key drivers of success.

Many people who’ve heard the compounding stories about how much more they’d have for retirement if they started saving in their 20s versus their 30s, would have likely felt very surprised.  Reason being is that the results intuitively don’t seem right.  Linear thinking is so much more intuitive than exponential thinking, and the counterintuitive nature of compounding leads even the smartest of us to overlook its force.

Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off wonders that are tricky to replicate.  Quite the opposite, sound investing is rather boring.  It’s about earning decent, consistent returns which can be repeated over extended periods of time.  That’s when compounding runs wild and wonderful.

We don’t always have the luxury of time, and time is not something we can turn back – it’s a limited resource.  But it’s never too late to begin.  Accumulating wealth is not a skill, it’s a habit.  And habits are the compound interest of self-improvement.  They rule nobody out.  If you are unwavering and dogmatic in your savings, and if you live below your means, you can cultivate the right behaviours to build wealth.  Be deliberate about where your money is going and feel worthy to pay yourself first, namely, to save today for a better life tomorrow.

By taking accountability for your savings, by starting, by being consistent, it’s unimaginable as to the magnitude of growth potential that lies ahead.