Thursday, April 12, 2007

Building An Asset Base Part 2 - On Compounding 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)

The whole idea of building a capital base is to let it compound itself. Over a long period of time, an unimpressive initial sum can compound itself into a great fortune --- Warren Buffett's 25-30% CAGR (compounded annual growth rate) over 40 years has grown his fortune by tens of thousands of times to his current US$40B.

You may also have heard the anecdote about an ancient Indian prince and a wise man who played a game of chess in which the latter won. Asked what he wanted as a reward, the wise man replied that he wanted only one grain of rice, doubled successively for every consecutive square on the chessboard (there were 64). The prince was amused and agreed only to find that he was ruined because if you double a grain of rice 64 times you end up with more rice than there was in all of India.

If the compounding rate is 100%/year, fortunes can be accumulated amazingly fast like in the above example. However clearly nobody achieves that kind of return consistently over an extended period (though I have heard of some who have already doubled their portfolios as of today compared to end-2006 --- a testimony of the 2007 bull market so far). Most academics put an achievable long-term return on the market at about 15%/annum.

There is an approximate rule known as the Rule of 72 used to find the number of years needed to double your money. Divide 72 by the expected percentage annual return, and you get the number of years required. If the annual investment return is about 15%, then 5 years would be needed. How many five years do we have in our life?

It makes sense to hence start early, have a substantial capital base to shorten the compounding process, and to have a prudent and consistent investing process from which one should not try to keep withdrawing from the fund (prudent consumption habits, as highlighted in the preceding article, would help). I also have some additional views on how to best utilise the so-called magic of compounding:

BHAG stands for Big Hairy Audacious Goal. It is an acronym introduced in the popular business/management bestseller Built to Last.

The idea is to set ambitious targets, and I believe this is applicable across all aspects of life, not just business management. It is the best way to keep one on his toes, a form of mental stimulation, so that he never sits on his laurels (or his stocks) and avoids what I have come to realise is one of the worst portfolio performance drags --- an inability to recognise opportunity costs.

Here you target for a high compounding rate to guide your investment/trading decisions. Not too high that it is unrealistic, but not too low as to be easily within reach. It is only through pressure (self-driven or not) that one learns best.

More on this in my writeup "Setting Investment Targets".

Frequency of compounding:
Instead of targeting an annual investment return, why not think in smaller time units? The principle of compounding will be more powerful the smaller the time unit: a monthly return of 2% compounded to one year is 27% ---- 3% higher than an annual return of 24%, for example. Compounded over many years, this difference will magnify.

Put in practice, this means one can make a case for trading at high frequency, to increase the compounding effect. However, in my view, it is predicated on two things: firstly, a favourable market (which I feel constitutes the strongest component of individual stock returns), and secondly, a competitive advantage that the investor possesses (or feels he does), such that he has a (maybe slightly) better chance of making money than the average market player. When these stars are in alignment, one presses the advantage. If not, then relak a bit lah.

More on this in my writeup "The Case for Trading".

I think it is often forgotten that a key ingredient for the magical compounding effect to work is time. As noted above in the rule of 72, it take 5 years to double your money assuming an annual return of 15%. It then follows that how many 5-years we have in our lifetime determines how much we can accumulate at the end of it (although some might feel it no longer matters at the end of our life ... well the point still stands).

Hence, our health is very important in asset accumulation. It is a long-term investment in itself .... an investment to augment the compounding effect. Poor health affects asset accumulation in three ways:
- You have to withdraw from the piggybank to fund medical expenses, depleting the capital base.
- Poor health compromises decision-making ability and drains the drive to constantly monitor one's investments/find new ideas.
- A shortened life cuts short the compounding effect (although you can teach your offspring how to fish and continue the compounding).

More on this in my writeup "The Importance of Physical Fitness".

The three points above target three different aspects of the compounding effect: the rate of return, the frequency of compounding, and the lifetime over which the compounding takes place. As long as one remembers the compounding principles, it is possible to find many other ways of improving the compounding effect which is the lifeblood of asset accummulation (leverage would be one additional example).




Post a Comment

<< Home