Category Archives: Building Wealth

10 Key Concepts About Money, Wealth and Financial Freedom

Posted on by

Brian Feroldi — financial advisor, YouTuber and author — posted on Twitter the key lessons he learned from the10 people that permanently changed the way he thought about money, wealth and financial independence:

  1. Financial independence is achievable if you hyper-focus on your savings rate.
    “Your time to reach financial independence depends only on one factor:  your savings rate as a percentage of your take-home pay.” ~ Pete Adeney
  2. Income and wealth are not the same things.
    “People who look rich may not actually be wealthy. Income does not equal wealth.” ~ Dr. Thomas Stanley, The Millionaire Next Door
  3. Putting what goods and services really cost in proper perspective.
    “The true price of anything is the amount of life you sold to buy it.” ~ Vicki Robbins
  4. Saving more money is more powerful and beneficial than making more income.
    “One dollar save is two dollars earned.” ~ David Chilton
  5. Your mind and mindset can be your greatest asset or your greatest liability.
    “Thoughts are powerful. Your mind is the one thing that can stop you in your tracks, or propel you to financial success.” ~ Napoleon Hill
  6. Money’s true highest purpose and benefit…financial independence and freedom.
    “Money’s greatest intrinsic value — and this cannot be overstated — is the ability to give you control over your time.” ~ Morgan Housel
  7. All spending is not created equally. Spend with purpose and according to your values. 
    “Spend extravagantly on the things you love, and cut costs mercilessly on the thing you don’t.” – Ramit Sethi
  8. Every financial decision you make involves a tradeoff and has an opportunity cost.
    “You can afford anything, but not everything. Every financial choice you make is a trade off against something else.” ~ Paula Pant
  9. There’s an optimal time to have positive life experiences. Don’t over-save and under spend on positive life experiences.
    “With each year that passes, our ability to convert dollars into positive life experiences decline over time.” ~ Bill Perkins
  10. Think like an entrepreneur, not a consumer. Buy assets with your personal capital that produce income and appreciate in value; and avoid personal liabilities and consumer debt.
    “Instead of taking a class, offer a class. Instead of borrowing money, lend it. Instead of taking a job, hire for jobs. Instead of taking a mortgage, hold a mortgage. Break free from consumption, switch sides, and reorient to the world as producer.” ~ MJ Demarco

Source: Twitter

Charles Schwab’s Five Steps to Financial Fitness

Posted on by

Below are five steps financial firm Charles Schwab encourages all investors to consider taking to boost their financial fitness at any time of the year.

Resolution 1: Create a budget

Committing to a saving and investing program during your working years is generally the best way to boost your net worth and achieve many of life’s most important goals. Of course, first you’ll need to know how much money you’ve got to work with. That’s where a budget and net worth statement can help. Here’s how to think about them.

  • Budget and save. At a minimum, be sure to have a high-level budget with three things: how much you’re taking in after taxes, how much you’re spending, and how much you’re saving. If you’re not sure where your money is going, track your spending using a spreadsheet or an online budgeting tool for 30 days. Determine how much money you need to cover your fixed monthly expenses, such as your rent or mortgage and other living expenses, and how much you’d like to put away for other goals. For retirement, our rule of thumb is to save 10%–15% of pre-tax income, including any match from an employer, starting in your 20s. If you delay, the amount you may need to save goes up. Add 10% for every decade you delay saving for retirement. Once you commit to an amount, consider ways you can save automatically, such as through monthly direct deposits.
  • Calculate your personal net worth annually. It doesn’t have to be complicated. Make a list of your assets (what you own) and subtract your liabilities (what you owe). Subtract the liabilities from the assets to determine your net worth. Don’t panic if your net worth declines when the market is struggling. What’s important is to see a general upward trend over your earning years. If you’re retired, you’ll want to plan an income and distribution strategy to help make your savings last as long as necessary and support other objectives.
  • Project the cost of essential big-ticket items. If you have a big expense in the near term, like college tuition or roof repair, put the money aside or increase your savings and treat that money as spent. If you know that you’ll need the money within a few years, keep it in relatively liquid, safe investments like short-term certificates of deposit (CDs), a savings account, or money market funds purchased within a brokerage account. If you choose to invest in a CD, make sure the term ends by the time you need the cash. If you have more than a few years, invest wisely, based on your time horizon.
  • Prepare for emergencies. If you aren’t retired, we suggest creating an emergency fund with three to six months’ worth of essential living expenses, set aside in a savings account. The emergency fund can help you cover unexpected but necessary expenses without having to sell more volatile investments.
  • Retired? Invest your living-expense money conservatively. Consider keeping 12 months of living expenses—after accounting for non-portfolio income sources like Social Security or a pension—in short-term CDs, an interest-bearing savings account, or a money market fund. Then consider keeping another two to four years’ worth of spending laddered in short-term bonds or invested in short-term bond funds as part of your portfolio’s fixed income allocation. You can use this money to cover expenses in the near term. Having a chunk of savings invested conservatively should allow you to invest a portion of your remaining savings for growth, at a level of risk appropriate for you, while reducing the chances you’ll be forced to sell more volatile investments (like stocks) in a down market.

Resolution 2: Manage your debt

Debt is neither inherently good nor bad—it’s simply a tool. It all depends on how you use it. For most people, some level of debt is a practical necessity, especially to purchase an expensive long-term asset to pay back over time, such as a home. However, problems arise when debt becomes more of a burden than a tool. Here’s how to stay in control.

  • Keep your total debt load manageable. Don’t confuse what you can borrow with what you should borrow. Keep the monthly costs of owning a home (principal, interest, taxes, and insurance) below 28% of your pre-tax income, and your total monthly debt payments (including credit cards, auto loans, and mortgage payments) below 36% of your pre-tax income.
  • Eliminate high-cost, non-deductible consumer debt. Try to pay off credit-card debt and avoid borrowing to buy depreciating assets, such as cars. The cost of consumer debt adds up quickly if you carry a balance. Consider consolidating your debt in a low-rate home equity loan or line of credit (HELOC), set a realistic budget, and implement a schedule to pay it back.
  • Match repayment terms to your time horizons. If you’re likely to move within five to seven years, you could consider a shorter-maturity loan or an adjustable-rate mortgage (ARM), depending on current mortgage rates and options. Don’t consider this if you think you may live in your home for longer or struggle to manage mortgage payment resets if interest rates or your plans change. We also don’t suggest that you borrow money under the assumption that your home will automatically increase in value. Historically, long-term home appreciation has significantly lagged the total return of a diversified stock portfolio. And, for any type of debt, have a disciplined payback schedule. Create a plan to pay off the mortgage on your primary home before you plan to retire.

Resolution 3: Optimize your portfolio

We all share the goal of getting better investment results. But research shows that it’s extremely difficult to always invest at the “perfect” time. So, create a plan that will help you stay disciplined in all kinds of markets. Follow your plan and adjust it as needed. Here are ideas to help you stay focused on your goals.

  • Focus on your overall investment mix. After committing to a savings plan, how you invest is your next most important decision. Have a targeted asset allocation—that is, strategically proportioned mix of stocks, bonds, and cash in your portfolio—that you’re comfortable with, even in a down market. Make sure it fits your long-term goals, risk tolerance, and time frame. The longer your time horizon, the more time you’ll have to potentially benefit from up or down markets.
  • Diversify across and within asset classes. Diversification can help reduce risk and can be a critical factor in helping you reach your goals. Mutual funds and exchange-traded funds (ETFs) are great ways to own a diversified basket of securities in just about any asset class.
  • Consider taxes. Place relatively tax-efficient investments, like ETFs and municipal bonds, in taxable accounts, and relatively tax-inefficient investments, like mutual funds and real estate investment trusts (REITs), in tax-advantaged accounts. Tax-advantaged accounts include retirement accounts, such as a traditional or Roth individual retirement account (IRA). If you trade frequently, do so in tax-advantaged accounts to help reduce your tax bill.
  • Monitor and rebalance your portfolio as needed. Evaluate your portfolio’s performance at least twice a year using a benchmark that makes sense for you. Remember, the long-term progress that you make toward your goals is more important than short-term portfolio performance. As you approach a savings goal, such as the beginning of a child’s education or retirement, begin to reduce investment risk, if appropriate, so you don’t have to sell more volatile investments, such as stocks, when you need them.
  • Choose appropriate benchmarks. Lastly, your benchmark to measure investment performance should match your portfolio and your goals. Don’t be tempted to compare your portfolio to what performed best in the market last year or even a portfolio invested 100% in stocks. You should have a portfolio selected to best meet your goals, with an appropriate balance of potential return and risk as well. Progress toward your goals is more important than picking the top-performing stocks each year—which, for any investor, isn’t possible to predict.

Resolution 4: Prepare for the unexpected

Risk is a part of life, particularly in investments and finance. Your financial life can be upended by all kinds of surprises—an illness, job loss, disability, death, natural disasters, or lawsuits. If you don’t have enough assets to self-insure against major risks, make a resolution to get your insurance needs covered. Insurance helps protect against unforeseen events that don’t happen often but are expensive to manage yourself when they do. The following guidelines can help you prepare for life’s unexpected moments.

  • Protect against large medical expenses with health insurance. Select a health insurance policy that matches your needs in areas such as coverage, deductibles, co-payments, and choice of medical providers. If you’re in good health and don’t visit the doctor often, consider a high-deductible policy to insure against the possibility of a serious illness or unexpected health-care event.
  • Purchase life insurance if you have dependents or other obligations. First, take advantage of a group term insurance policy, if offered by your employer. Such programs don’t generally require a medical check and can be a cost-effective way to provide income replacement for dependents. If you have minor children or large liabilities that will continue after your death for which you can’t self-insure, you may need additional life insurance. Unless you have a permanent life insurance need or special circumstances, consider starting with a low-cost term life policy before a whole life policy.
  • Protect your earning power with long-term disability insurance. The odds of becoming disabled are greater than the odds of dying young. According to the Social Security Administration, a 20-year-old American has a 25% chance of becoming disabled before normal retirement age and a 13% chance of dying before retirement age.1 If you can’t get adequate short- and long-term coverage through work, consider an individual policy.
  • Protect your physical assets with property-casualty insurance. Check your homeowner’s or renter’s and auto insurance policies to make sure your coverage and deductibles are still right for you.
  • Obtain additional liability coverage, if needed. A personal liability “umbrella” policy is a cost-effective way to increase your liability coverage by $1 million or more, in case you’re at fault in an accident or someone is injured on your property. Umbrella policies don’t cover business-related liabilities, so make sure your business is also properly insured, especially if you’re in a profession with unique risks and aren’t covered by an employer.
  • Consider the pros and cons of long-term-care insurance. If you consider a long-term-care policy, look for a policy that provides the right type of care and is guaranteed renewable with locked-in premium rates. Long-term care typically is most cost-effective starting at about age 50 and generally becomes more expensive or difficult to find after age 70. You can get independent sources of information from your state insurance commissioner. A sound retirement savings strategy is another way to plan for long-term-care costs.
  • Create a disaster plan for your safety and peace of mind. Review your homeowner’s or renter’s policy to see what’s covered and what’s not. Talk to your agent about flood or earthquake insurance if either is a concern for your area. Generally, neither is included in most homeowner’s policies. Keep an updated video inventory of valuable household items and possessions along with any professional appraisals and estimates of replacement values in a safe place away from your home.

Consider storing inventories and important documents on a portable hard drive. It’s also a good idea to have copies of birth certificates, passports, wills, trust documents, records of home improvements, and insurance policies in a small, secure evacuation box (the fireproof, waterproof kind you can lock is best) that you can grab in a hurry in case you have to evacuate immediately. Make sure your trusted loved ones know about this file as well, in case they need it.

Resolution 5: Protect your estate

An estate plan may seem like something only for the wealthy. But there are simple steps everyone should take. Without proper beneficiary designations, a will, and other basic steps, the fate of your assets or minor children may be decided by attorneys and tax agencies. Taxes and attorneys’ fees can eat away at these assets and delay the distribution of assets just when your heirs need them most. Here’s how to protect your estate—and your loved ones.

  • Review your beneficiaries, especially for retirement accounts, annuities, and life insurance. The beneficiary designation is your first line of defense, to make your wishes for assets known, and ensure that they transfer to who you want quickly. Keep information on beneficiaries up-to-date to ensure the proceeds of life insurance policies and retirement accounts are consistent with your wishes, your will, and other documents.
  • Update or prepare your will. A will isn’t just about transferring assets. It can provide for your dependents’ support and care and help you avoid the costs and delays associated with dying without one. It can also spell out plans to repay debts, such as a credit card or mortgage. Keep in mind that a beneficiary designation or asset titling trumps what’s written in a will, so make sure all documents are consistent and reflect your desires. When writing a will, we recommend working with an experienced lawyer or estate planning attorney.
  • Coordinate asset titling with the rest of your estate plan. The titling of your property and non-retirement accounts can affect the ultimate disposition and taxation of your assets. Talk with an estate attorney or lawyer about debts and the titling of assets, such as a home, that don’t have a beneficiary designation, to make sure they reflect your wishes and are consistent with titling laws that can vary by state.
  • Have in place durable powers of attorney for health care. In these documents, appoint trusted and competent confidants to make decisions on your behalf if you become incapacitated.
  • Consider a revocable living trust. This is especially important if your estate is large and complex, and you want to spell out how your assets should be used in detail, or if you have dependent children and want to spell in detail how assets should be managed to support them, who will manage the assets, and other issues. A living trust may not be needed for smaller estates where beneficiaries, titling, and a will can be sufficient, but talk with a qualified financial planner or attorney to be sure.
  • Take care of important estate documents. Make sure a trusted and competent family member or close friend knows the location of your important estate documents.

Finally, remember you don’t have to do everything at once. There’s a lot you can do to improve your financial health by taking one step at a time and think of these resolutions as a checklist. Make some real progress on your journey this year.

1Johanna Maleh and Tiffany Bosley. “Disability and Death Probability Tables for Insured Workers Who Attain Age 20 in 2022.” Social Security Administration, December 2022.

It Takes Courage

Posted on by

It takes courage to leave your comfort zone, it takes courage to go after your dreams, it takes courage to live a life worth remembering. It’s very easy to die, it takes courage to live.

It takes courage to grow and become all you are destined to be, it takes courage to embrace the possibilities of your potential, it takes courage to go after what you desire. It’s very easy to stop, it takes courage to keep climbing until you reach the top.

It takes courage to look at your failures and still choose to try again, it takes courage to meet with fierce opposition and still choose to fight, it takes courage to endure pain, and choose to be strong. It’s very easy to fall, it takes courage to stand.

If you have tried and met with defeat, If you have planned and watched your plans fail, If you have given your all and again you lost,
Remember that the great men and women who have lived before us were all products of courage.

Courage doesn’t mean you don’t get afraid, it means you don’t let your fear stop you.

You can’t swim for new horizons until you have the courage to lose sight of the shore. You can’t become all you are destined to be until you have the courage to leave where you used to be.

The great things of life that you so much desire is on the other side of fear, you need courage to go after and possess them.

Don’t be numbered among the fearful ones who neither achieve greatness nor experience defeat, who neither enjoy the thrills of success nor learn the lessons of failure.

Go out into the world, it’s time to start living. Face your fears, fight your battles, it’s time to conquer, that’s what you are made for, that’s why you are here.

Source: MordyQuotes (https://mordyquotes.com/quotes/)

Return on Invested Capital

Posted on by

Investors should give serious consideration to a company’s return on invested capital (ROIC) before they invest in a company by purchasing that company’s stock.

Investor educational company, Compounding Quality, provides the following example. Suppose that there are 2 companies:

  • Company A: ROIC of 5% and reinvests all its profits for 25 years
  • Company B: ROIC of 20% and reinvests all its profits for 25 years

Can you guess how much company A and B would be worth if you invested $10,000 in both (assumption: valuation remains constant)?

In this example, an investment in company A would be worth $33,860 while an investment in company B would increase to $953,960!

This simple example beautifully shows the importance of ROIC and the power of compounding.

ROIC is a measure of how much cash a company gets back for each dollar it invests in its business.

ROIC is a much better predictor of company performance than either return on assets or return on equity. In ROA and ROE, the key metric is net income. Net income often has nothing to do with the profitability of a company. Significant expenses are not included in net income such as interest income, discontinued operations, minority interest, etc. which can make a company look profitable when it is not.

Also, ROA measures how much net income a company generates for each dollar of assets on its balance sheet. The problem with using this metric is that companies can carry a lot of assets that have nothing to do with their operations, so ROA isn’t always an accurate measure of profitability.

Companies with higher-than-median ROIC (when viewed in conjunction with their overall capital-expenditure and operating-expenditure strategy) will deliver better returns over the long term. A high ROIC rewards companies that are able to produce the highest net operating profit with the least amount of invested capital.

What does ROIC mean?

Return on Invested Capital ratio provides insight into the extent to which a company efficiently allocates capital to profitable investments or projects, thereby generating returns. Comparing the ROIC to the weighted average cost of capital (WACC) reveals whether or not this is happening effectively.

ROIC basic formula

The basic formula for ROIC is as follows:

Image placeholder title

ROIC uses net operating income after tax (NOPAT) in the numerator. This is obtained by reducing EBIT (“Earnings Before Interest and Tax”) by the prevailing tax rate.

For the denominator, this ratio uses invested capital. That equals total assets (current and fixed assets) minus non-interest-bearing current liabilities (all current liabilities excluding bank loans and leases).

  • Current assets = all items that are relatively easy to convert to cash such as inventories, trade receivables, cash investments and cash.
  • Fixed assets = all operating assets used by the company for a long time such as land and buildings which are considered tangible fixed assets. However, there are also intangible fixed assets to be taken into account, such as patents and goodwill.
  • Current liabilities = current liabilities with a maximum repayment period of one year such as, for example, supplier credit or taxes payable.

Relationship between ROIC and WACC

Revenue growth and return on invested capital are the basis of value creation. However, regardless of revenue growth, the return on invested capital must always exceed the cost of capital. Even high sales growth combined with too low a ROIC will always result in loss of value. After all, excessive costs eat into profits. So, reducing costs takes precedence over revenue growth.

The cost of capital includes the minimum expected weighted average return (WACC) of all investors for bearing the risk that the future cash flows of an investment may deviate from expectations.

Consequently, the ROIC result should always be compared against the WACC. Only when the ROIC is greater than the WACC can it be concluded that the company is earning more than the cost of capital and thus creating value. The formula to calculate the Weighted Average Cost of Capital is equal to the firm’s average cost of capital (cost of equity + cost of debt).

The basic ROIC formula includes by default all excess cash, goodwill and acquired intangible assets (patents, brands, etc.). If you use a minimum ROIC of say 15%, you will already be able to eliminate a lot of companies from your list. What remains are companies for which you know with certainty that they create value.

As an investor, you are searching for companies that are cash flow and earnings compounding machines. These companies have a high and consistent ROIC with plenty of reinvestment opportunities. This will allow the company to grow its free cash flow exponentially.

References

  1. https://qualitycompounding.substack.com/p/what-you-need-to-know-about-return
  2. https://www.chartmill.com/documentation/fundamental-analysis/indicators-and-ratios/416-Return-on-Invested-Capital-ROIC
  3. https://www.thestreet.com/opinion/10-stocks-with-high-return-on-invested-capital-and-why-you-should-care-13279076

Collagen

Posted on by

Collagen is the single most abundant protein in the human body. Mayo Clinic


Collagen’s main purpose is to impart physical structure. Your bones are built on a matrix of collagen, your organs are held together by collagen, your skin is composed of a dense network of collagen, your joints are made-up of collagen, even your blood vessels rely on collagen for structural integrity. Needless to say, collagen is an all-important substance that is vital to health, beauty and well-being.

Collagen is concentrated in bones, ligaments, tendons, skin, blood vessels and internal organs. It helps provide elasticity and strength. As you age, you begin to lose the collagen within your body, and it becomes harder for you to make more.

At least 30 percent of your body’s protein content is made from collagen. Collagen is made from four amino acids, which are the building blocks for protein: proline, glycline, lysine and hydroxyproline. These amino acids are grouped together in a form known as a triple helix, and that is what makes up collagen. For this triple helix to be formed, you need to have enough vitamin C, zinc, copper and manganese in your diet.

Within the human body, 29 types of collagen have been identified, with three types making up the vast majority, according to the Mayo Clinic.

These are the types you’ll usually find in a collagen supplement:

  • Type 1 – This type is found in bones, ligaments, tendons and skin for elasticity and strength. The supplement source comes from bovine and fish.
  • Type 2 – This type is cartilage. The supplement source comes from chicken cartilage and joint.
  • Type 3 – This type is found alongside type 1 in skin, blood vessels and internal organs. The supplement source comes from bovine.

From a general health perspective, it is important to ensure adequate protein within your diet. As you age, your protein needs increase slightly to maintain lean body mass. Consuming foods that contain the primary amino acids that make up collagen may help support skin, hair, nail and joint health as you age.

These foods are good sources of glycine, proline, lysine and hydroxyproline:

  • Bone broth
  • Unflavored gelatin
  • Dairy, especially parmesan cheese
  • Legumes
  • Non-genetically modified soy, such as tofu
  • Spirulina
  • Animal sources, such as red meat, poultry, pork, fish and eggs

To support the formation of collagen, it is also important to ensure adequate intake of foods that contain vitamin C, zinc, copper and manganese, writes the Mayo Clinic. These nutrients can be found by eating a varied diet rich in fruits and vegetables, including green leafy and root vegetables, along with nuts and seeds – especially hemp, pumpkin and cashews.

Finally, being mindful of what can damage collagen production is important. Such factors include excess sugar intake, smoking, sun exposure or ultraviolet light, and environmental pollutants.

Unfortunately, collagen breaks down with age and diminishes over time. This loss of collagen is believed to be a primary cause of “aging” and has been linked to numerous health issues – including weaker joints, thinner cartilage and dry, wrinkled skin.

Collagen supplements can deliver targeted nutrition and bioactive collagen peptides to help counteract the loss of collagen as you age.

If you are planning to take a collagen supplement, either in liquid or powder form, it is important to mention that the triple helix that makes up collagen is unable to be absorbed in its whole form, according to the Mayo Clinic. It will first be broken down into individual amino acids within the gastrointestinal tract before reaching the bloodstream. The body will then reassemble and form new proteins where it sees necessary and for a use it feels is needed.

These new proteins may not contain the same amino acids that were initially ingested in the collagen supplement, and it is unknown if these restructured proteins will target the area a supplement manufacturer is advertising. Therefore, it is undetermined at this time if the body will use a collagen supplement that is purported to help skin, hair, nail and joint support to actually make collagen that would do so. In addition, limited large and long-term randomized control trials support the use and recommendation for collagen supplements for the general public.

Hydrolyzed collagen supplements advertise that they are a special type of protein that is “pre-digested” or broken down into smaller peptides for enhanced absorption into the body. Several studies have demonstrated that hydrolyzed collagen peptides are quickly absorbed after ingestion and readily deposited in the body’s tissues, where they act as building blocks and may help to trigger your body’s own internal collagen production.

Source:  https://www.newstribune.com/news/2021/aug/31/Mayo-Clinic-Q-A-Collagen-and-biotin-supplements/

FTC Proposes to Ban Noncompete Clauses

Posted on by

The Federal Trade Commission proposed a rule to prohibit employers from imposing noncompete clauses on employees — a widespread practice that economists say suppresses pay, prevents new companies from forming and raises consumer prices, according to a Washington Post article.

The ban would make it illegal for companies to enter into noncompete contracts with employees or continue to maintain such contracts if they already exist, and it would require that companies with active noncompete clauses inform workers that they are void. Such agreements typically prevent workers from getting jobs at a competitor of a current or former employer for a defined period.

The FTC estimates that banning noncompete contracts would open new job opportunities for 30 million Americans and raise wages by $300 billion a year. If enacted, the rule could send shock waves across a wide range of industries.

One widely cited survey of economists from 2014 found that close to 20 percent of workers in the United States are bound to noncompete clauses across a variety of jobs, from hairstylists to software engineers to nurses. These contracts have forced workers to take on loads of debt during lengthy job searches, locked workers out of their own professions or shunted them into lower-paying industries.

A growing body of research shows that noncompete contracts reduce wages and mobility for workers across various industries by ensuring that employers do not have to compete against one another for workers by raising wages or improving working conditions.

The U.S. Chamber of Commerce contends in a letter to the FTC that reasonable non-compete clauses are pro-competitive because they protect an employer’s special investment in, training of and disclosure of sensitive business information to its employees. For these reasons, state legislatures and courts nationwide continue to protect and enforce such clauses. Moreover, in recent years, many states have adopted non-compete laws that restrict non-compete clauses in order to prevent abuses and to regulate to whom they may be applied, the circumstances in which they are appropriate, and to ensure procedural protections.

References:

  1. https://www.washingtonpost.com/business/2023/01/05/ftc-noncompete-ban-lina-khan/
  2. https://www.uschamber.com/assets/documents/210927_comments_noncompete_clauses_ftc.pdf

The Power of Compounding

Posted on by

There are two things to direct your attention to.

  • First, the power of compounding. A 12% return in one year isn’t life changing, but stay invested for 20 years and, on average, you’ve grown your capital nearly ninefold.
  • Second, notice that the lowest number on the chart is the worst one-year return, a 39% loss. As the time extends, not only do the average results improve, but the worst losses also get smaller.

Over the long-term, the worst 20-year S&P 500 returns result has been a gain of 155%. The fact that risk decreases with time is apparent in the annualized standard deviations, which are lowest for the longest holding periods. That means the annual returns are not independent of each other, but rather, are mean reverting. And that’s good to know after a year like this year.

That’s why buying stocks only for investors who can leave their money in the market for multiple years is encouraged. If you expect to cash in your stocks in just a year, you expose yourself to a loss that is multiples of your expected gain. If you can wait five years to cash in, your expected gain is multiples of the worst historical loss. And if you can wait 20 years, there has never been an outcome worse than doubling your investment.

You shouldn’t buy stocks if you expect to sell within five years. And you’re  also discouraged market timing. Most investors tend to throw in the towel after large losses and go all in after large gains. History says the opposite has produced better results market tended to increase more than usual following a bear market. The average two-year increase was 33% after hitting down 20%, meaning the market had usually recovered more than all its losses within two years. Further, that 33% gain was nearly double the median two-year increase. This positive outlook can be hard to wrap your arms around given that most advice you hear, especially from professionals, is to get more cautious after the market has fallen.

The tendency of good periods following bad and vice versa is part of the reason why the long-term risk-return characteristics of equities have been so favorable. The table below shows the average 1-, 5-, 10- and 20-year total returns for the S&P 500 for the past 77 years and the best and worst returns for each period.

References:

  1. https://oakmark.com/wp-content/uploads/sites/3/documents/2022-0930_Oakmark-Funds_Annual_Report.pdf