Taking a Long-Term Perspective
It doesn’t take much study to learn that financial markets are full of risks. Today we see a long bull market stretching valuations in the US, Italian political troubles, a North Korean nuclear threat, rising interest rates, escalating tensions over global trade, and then, of course, the unknown unknowns of black swan events.
In light of these risks, many investors are taking what they think is the prudent course: holding cash, waiting for the next big pullback, sitting out a few innings.
But are there hidden costs to this seemingly prudent strategy? The math of compounding means that most of the dollar gains to investing come after many years of staying fully invested in a consistent strategy.
Investor and author Morgan Housel notes that this is an underappreciated element of Warren Buffett’s success. “There are over 2,000 books picking apart how Warren Buffett built his fortune,” noted Housel. “But none are called This Guy Has Been Investing Consistently for Three-Quarters of a Century.”
To illustrate this mathematically, consider three hypothetical investments, one yielding 5% per year, one yielding 10% per year, and one yielding 15% per year. Let’s look at what $1M invested in each investment would be worth after 5, 10, 15, 20, 25, and 30 years.
Figure 1: Compounding Math on Three Hypothetical Investments
Over long horizons, compounding has the power to dramatically increase your wealth. Now let’s think of the costs of waiting just one year to invest.
Figure 2: Compounding Math on Three Hypothetical Investments Less One Year
These numbers, as you can see, are significantly lower than the first table. The final table shows the foregone gains from missing a year of compounding as a percent of the original $1M investment.
Figure 3: Foregone Gains (% of Original Investment)
If you’re looking out 30 years, waiting one year to decide whether to invest in a 5% yielding asset would cost you 21% of your original investment. In a 10% yielding asset it would cost you 159%, and in a 15% yielding asset it would cost you 864% of your original investment. A little prudence could cost a lot in terms of lost future gains. Or, as one of the old investment proverbs puts it, “It’s time in the market that builds returns, not market timing.”
The problem with taking a long-term perspective is that it requires accepting risk today. Next week, we will look at the historical base rates of returns in equities to help bound those risks.