The Compounding Advantage

The Compounding Advantage

It’s noteworthy how many luminaries have invoked the mathematical concept of compounding through time. Investment legend Warren Buffett discovered the compounding principle at a young age and compared it to snowballing. Ben Franklin, an American founding father and polymath, described the concept like this: “Money makes money. And the money that money makes, makes money.”

Yet we believe not enough investors have a firm enough grasp of the power of compounding and how vital it is to wealth accumulation over an investing lifetime. One basic rule of compounding is not to interfere with it (i.e., to stay invested instead of attempting to time markets). Let’s consider some fundamental math and behavioral finance concepts.

Some Investing Math

First, some axioms of math: It takes a long time to recover from severe investment losses. The bar chart below depicts the investment gains required to recoup losses of various severities. For instance, suppose a fund loses 50% in one year and gains 100% the following year. Note that the “average” return in these two years is 50% (-50+100), but the investment (or compounded) return is 0!

Winning the Compounding GameOne investment (and math) lesson is that, the higher the volatility and the more dispersed a series of return numbers are from the average, the lower the compounded return. But there is an added, external element as well that comes into play: investor behavior. Unless an investor has ice running through his veins, he is prone to human emotions such as fear or greed that will cause him to buy and sell at inopportune times.

Morningstar* often measures the gap between investor (or dollar-weighted) returns in mutual funds and time-weighted or compounded returns (i.e., fund performance). They typically conclude that, due to ill-timed fund inflows and outflows, investors earn about 1.7 percentage points less per year than the funds’ actual returns—a deficit that is huge, due to the compelling math of compounding, when you consider the toll it takes on a portfolio over an investing lifetime.

Typically, the higher a fund’s anxiety-inducing volatility, the wider the gap between the fund’s return and its shareholders’ returns. For instance, Morningstar analyzed the respective returns for one sizeable growth fund that is more than twice as volatile as its benchmark and whose peak drawdown of more than 75% was also double that of its fund category and index bogeys. In some years it ranked in the top percentile of its category and in others the bottom percentile. During the eight years to 2021, the average investor return trailed the fund’s return by 18 points annualized! Extreme turbulence shook investors from their seats. This may be an extreme example, but you get the point.

As the math (e.g., to make up a 60% loss you need a 150% gain) and investor behavior make clear, to harness the felicitous power of compounding one should keep an eye on volatility and endeavor to limit steep losses during the inevitable periods of equity drawdowns. Obviously, you need to participate in up markets and stay invested for compounding to be your friend and work long term. In baseball parlance, you can think of it as hitting singles (okay, maybe a few doubles also) rather than swinging for the fences.


So we believe the parameters a successful long-term wealth-building approach seem clear—an investment strategy that generates attractive compounded returns over time with strong risk mitigation characteristics to limit the severity of portfolio drawdowns (the math mandate) and the volatility of returns (the behavioral finance goal). There is more than one way to pursue this goal, but we believe one sound approach is a well-managed long-short equity strategy that participates in stock market upside while utilizing downside risk management and reducing volatility. We believe an investor who maintains asset value during periodic bear market cycles is well positioned to start adding to stocks in times of discounted prices.

*Source: Morningstar, “Mind the Gap 2023: A Report on Investor Returns in the United States,” July 31, 2023


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