Where would the Manhattan Indians be today if they invested their 60 Guilders (US$ 24) wisely?
Since 2008, many investors have solely been focused on the risk of one’s investment in a portfolio of assets or in reference to a single asset. Risk is an important factor as one endeavors to derive a return for a given portfolio or single asset. However, one of the factors that appears to have been overlooked in this period has been realizing an attractive compound return over the life cycle of one’s investing horizon. Investors significantly benefit from the compounding of long-term returns. In fact, the logic of investing long-term and deriving an attractive long-term average rate of return, from relatively few investment decisions, may have caused investors to sub-optimize their wealth in their lifetime and beyond.
The compounding of excess returns from securities and/or businesses is most likely to be derived from the propensity of the investment to be resilient to economic volatility and where earnings are maximized and retained through the foresight of deliberate management. And thus, investing capital, via securities or a business, for the long-term, where the investment compounds at a rate of interest, within a defined risk parameter, is very likely to produce excess returns versus short-term speculation/trading activity. While such an approach may sound logical, even simple, it goes against most of the hype one hears, reads and sees in the media, “trade the momentum”.
While compounding returns does not necessarily imply a smoothing of returns, it does point towards a repetitive consistency of returns that enables the benefits of compounding to produce long-term excess returns. To maximize one’s result, reproducing positive returns over time, without excessive drawdowns, reduces the prolonged stagnation of returns and enabling growth of assets through a compounding of results with a high probability.
The accompanying table demonstrates the power of compounding returns, considering taxes at differing rates and holding periods. The top two charts assume an investment of $1 double each year. In the chart on the left, the investment is sold at the end of the year, causing a tax of 39.6% is paid on the proceeds (assuming it is considered short-term gain of less than one year). The after-tax proceeds are then reinvested and process is repeated for 19 more years. After 20 years, $8,331 was paid in taxes, leaving the investor with a gain of $12,707. In the chart on the top right, the security doubles every year for 20 years and a tax of 23.8% was paid at the end of the 20 year period (this assumes the current maximum long-term capital gains tax rate for holding in excess of one year). In this circumstance, the investor’s $1 would have grown to $799,014, after having paid taxes of $249,561. The lower two charts employ the same methodology, assuming a 7% return each year on an investment of $100,000. The result is effectively the same, long-term investment and deferring taxes enhances compound returns.
A real life example of the benefits of compounding and the impact of differing rates of return can be seen in return realized by Boston and Philadelphia from a bequest in Ben Franklin’s will. Over 200 years ago, Ben Franklin bequeathed each of the cities $:1,000 sterling, with one qualification: much of the money could not be drawn on for 100 years, and the rest could not be distributed for 200 years. In 1990, Franklin’s bequest was worth $6.5 million. The balance in the Boston trust was $4.5 million, while the money in the Philadelphia account was valued at $2 million. “The large difference in the value can be traced to the wiser handling of the investment in Boston”, stated Whitfield Bell, a historian and the curator of the American Philosophical Society in Philadelphia. An excellent example of time and rates of return defining the impact of compounding.
It is clear, given the impact of both taxes and compounding returns investors should focus their attention on making fewer, but strategically more targeted long-term investment decisions. Investing for the long-term means focusing on compounding returns.