LET COMPOUNDING DO ITS WORK
Hendrik Bessembinder’s latest paper asks the question – which US stock has generated the highest long-term returns? The answer is Altria Group (formerly known as Philip Morris). Over 98 years the tobacco company produced a cumulative return of 265 million percent! Based on this it would be easy to write about how lucrative it can be to sell addictive products, particularly when there are negative externalities involved, but there is something more important for investors to take away from the research – the power of compounding over the passage of time.
The cumulative total return of Altria seems astonishing, yet it equates to an annualised return of ‘only’ 16.3%. On a standalone basis the figure does not seem remarkable, it is only when you apply time to it – long periods of time – that the dramatic impact of compounding takes hold.
Investors are inevitably drawn to high short-term returns (far higher than the 16.3% per annum produced by Altria), but these are inevitably unsustainable. That’s not an opinion, it is a mathematical reality. There is an inescapable gravitational pull as both time and size drags astronomical performance back toward normality.
Most investors neglect the power of time and the monumental advantage it bestows upon those with a sufficiently long horizon. We behave as if we are attempting to generate the highest possible return in the shortest possible time. Instead of compounding solid returns, we become destined to compound a succession of poor decisions with painful long-term consequences.
It is not surprising that investors act in this fashion. We are wired to worry about and act on short-term risks and opportunities – it is a great strategy for evolutionary survival, just a terrible one for long-term investing. But it is more than that. The entire industry wants us to be impatient – whether it be selling the next great product or attracting our attention with the next alarming article.
Everything within us and around us seems designed to interrupt the positive force of compounding.
Investors who understand their time horizon, build a sensible portfolio and rarely make changes will be far better off than most. The trick is understanding ourselves and our environment well enough so that we avoid the temptation to veer from that course.
Despite it being the best strategy for most investors, doing nothing (or at least very little) has a very bad reputation, so maybe it needs a rebrand. Instead, from now on, let’s call it: ‘Letting compounding do its work’.
Author: Joe Wiggins
Source: Behavioural Investment
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