The Power of Compounding

SG Hiscock & Company
Stratton Bell
Stratton Bell
SG Hiscock Analyst
0
Since the dawn of time, the humankind has looked up at the vast universe and wondered, pondering the questions that we are unlikely to solve in this life.

Does God exist? Is there life after death? Why is there something rather than nothing? Many have thought and hypothesised ranging to what seems like an innumerous number of possible outcomes; albeit we may never know. 

The frailty of the human mind can be explored further in what we find difficult to comprehend – we understand that the universe is unlimited, however, do we fathom how the universe could be unlimited and have no end? The system of blood vessels in the body would stretch out top over 100,000 kms – even I can’t grasp that!

Another topic that we fail to fully comprehend is the law of compounding. This is where reinvested capital growth generates additional earnings and this growth is calculated using exponential functions as earnings are generating from both principal and accumulated earnings from preceding periods. Sounds complex, but what it means it that 5% growth on $100 is $5, but then 5% growth on the next period is $5.25, and so on.

The extent of our misunderstanding is illustrated through the fable of the rice and the chessboard. As the story goes, the king was so impressed by the game of chess, he offered the investor any reward. The investor chose one grain of rice to be placed on the first square, two grains on the second, four grains on the fourth, etc where the pieces of rice double across each square until it reaches the 64th, and final, square.

The king was obviously excited that the investor would ask for such a small reward and agreed to the investor’s request. Little did the king know, but that the total value of rice from the first half of the chessboard was already more than what the entire kingdom possessed. 

He couldn’t believe that to be true; how many pieces of rice do you think would be on the board? I posed this exact same question to my extended family over the Christmas period. They responded with a low and high range of one million to five billion – this five billion estimate was laughed at almost everyone as they thought ridiculously too high. 

Little did they know that this high estimate of 5 billion grains on rice was actually lower by -99.99999997% or -3.7 billion times than the actual figure. The correct answer of pieces of rice on the chessboard is over 18 quintillion – that is a number with 20 digits! To put this into perspective, this amount of rice is ~1,645 times the global wheat production (total production was 780.8 million tonnes in 2019)!

It’s a nice tale, but what does this have to do with investing? There are two lessons for investing that investors often overlook and/or forget being 1) investors underestimate the power of compounding and 2) market timing is very difficult.

Watching the news or speaking with friends over a casual barbeque, hot stocks that have blitzed the market might come up. A friend might say “Did you know Xero has returned 148% since the bottom of the pandemic?”, only to be interrupted and trumped by another with “If you think that’s great, Afterpay is now up 1,231% over the same period!”. 

These success stories are all too common. Upon hearing those returns and comparing them to one’s total portfolio return, one might feel jealous or FOMO (fear of missing out) by rushing out and trying to find the “next ten-bagger”. Whereas the sensible investor would be able to put these returns into perspective in understanding the power of compounding. 

In trying to visualise the power of compounding, we will use a 9% return (roughly the long-term equities return) – but 9% doesn’t sound too impressive does it? However, with those earnings reinvested, it takes less than 9 years to double one’s money, less than 13 years to triple, and almost 16 years to quadruple. This is how real wealth is generated through stable, consistent returns. While 9% doesn’t seem like much, year after year it all adds up.

At the end of 2019, your barbeque friend might have mentioned “did you see the price of Avita Medical? It is up 700% over the past 12 months and is now in the ASX 300!”. Fast forward to today, the stock price has fallen by over 60% and those superb returns become a lot less superb. Often chasing very high growth yields very high risk. 

This brings to the next topic – market timing is very difficult. Attempting to time the market has left many investors with subpar returns and negates the benefits of compounding returns. While one may miss some of the negative returns in attempting to time the market, they will also miss out on much of the upside. In the short term, we believe the market is quite efficient and new information is discounted and priced in stock prices in a short time frame (the market is less efficient over the long term, but this is another topic for another day).

Source: Iress

Looking at the past 12 months, the ASX300 Accumulated Index returned 1.7%. If one was trying to time the market and missed the best day of the 2020 calendar year, their portfolio would have returned 6.9% lower, equating to a total return of -5.1%. If this particular investor missed the three best days, their portfolio would have a returned a very ordinary -16.4% or -18.1% less than the market.

These volatile strong returns are extremely hard to predict, but if one is not fully invested, then they aren’t benefiting from compounding returns. One of my favourite athletes growing up was Wayne Gretzky (NHL – ice hockey – player) who stated, “You miss 100% of the shots you don’t take”. This holds true for investing too – you miss out of 100% of the gains of the market when you’re not invested.

Learn more
OUR PROCESS

We believe in buying great companies at good prices. We are firm believers in co-investment, demonstrated by our significant investment in our own funds. Our confidence in our investment approach means we always seed new funds with our own money. We have made the decision to cap our Funds Under Management at modest levels, to ensure that the funds retain greater flexibility to generate strong investment returns across varying market conditions. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.

OUR ENVIRONMENTAL, SOCIAL AND GOVERNANCE POLICY

SG Hiscock & Company has a formal board-endorsed environmental, social and governance (ESG) policy. This incorporates the key principles of the Australian Council of Superannuation Investors, as well as the framework provided under the United Nations’ Principles for Responsible Investment. SG Hiscock & Company is a responsible investor and we take an active approach to integrating ESG considerations into our investment decision-making process. We believe that the effective governance and management of business risks has a direct impact on a company’s intrinsic value over the long term and helps to reduce investment risk. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.