It’s about time

The exponential function or exponential growth has been a matter of great concern and newsworthiness in 2020 and early 2021, for obvious reasons.

Thankfully there are some reasons to believe that a novel coronavirus may burn out naturally in time, while humans tend to build up a level of immunity to viruses, and the speed of vaccine developments has also given grounds for optimism.

It’s often said that “compound growth is the most powerful force in the financial universe”, or various words bent around to that effect, but how well do we really understand it?

The eighth wonder

I’ve long been interested in the power of compound interest – indeed I wrote a book on it years ago – but it’s interesting to note how few businesses, assets, or organisms can genuinely sustain compound growth for very long periods of time.

Even one example I used in my book, being the explosive growth of the rabbit population of Australia, was eventually dampened through a combination of biological control measures (poisoning and the release of rabbit-borne diseases), shooting, trapping, and fencing.

The concept of the power of compounding recently hovered back onto my radar when I read the brilliant book The Psychology of Money by Morgan Housel, wherein he observes that the most impressive financial results are often achieved by those allowing compound interest to run wild for the longest period of time.

The financial winners tend to be those that don’t succumb to greed, observes Housel, and those that can avoid becoming spooked when an investment strategy experiences leaner years.

Buffett’s sidekick Charlie Munger once said that the first rule of compounding is to never interrupt it unnecessarily (and those guys should know, having compiled most of their wealth beyond the traditional retirement date).

Investment lifespan

Author and entrepreneur Robert Kiyosaki wrote that your financial life might be thought of like a game of American Football, divided roughly into four quarters.

Until the age of about 25 we’re often studying or striving to find our place in life. Then in the first quarter of the game, from 25 to 35 years of age, we begin to increase our earning capacity and learn about the wider world, hopefully not becoming too seduced by consumer credit and lifestyle inflation.

Think back to what you were doing 10 or 15 years ago, and how much life has changed for you since that time, and you may begin to get a sense of how tough it is to design a long-term investment strategy to allow compounding to continue multiplying your results.

Herein, then, lies the challenge: how can you allow the power of compound interest to flourish for the longest possible period of time?

Jolly hockey sticks

We often see charts showing apparently neverending ‘hockey stick’ style growth, including when it comes to living standards.

A longer run look at GDP per capita plotted on a logarithmic scale would show that there were long, drawn-out stretches through history where living standards barely improved at all.

But from around the time of the industrial revolution things really took off (and then some!).

Looking at real U.S. GDP per capita you could certainly make the case that the rate of growth may be slowing since the early 1980s, especially after the recession of 2020.

But most optimists would say that thanks to advancements in technology overall living standards can continue to rise at a fairly consistent pace from here.

Compounding in reverse

If there’s one thing that depresses me in personal finance it’s those adverts for payday loans or other finance solutions where the small print shows annual percentage rates running into the thousands.

The debts mount up, and then more interest is charged on the new outstanding balance.

This is a tremendously effective business model for generating assured compound growth, no question, but it works endlessly and egregiously against the hapless consumer.

Defying gravity

It’s quite common for younger businesses to present charts showing or projecting ‘hockey stick’ growth in their customers and revenues, but the truth is that relatively few established businesses can sustain genuine compound growth for long periods of time.

Amazon is a rare and outstanding example of a business that has continued to experience compound growth in its revenue and customer base through expanding into new products and markets, partly through eschewing the drive for bottom line profits.

While many companies are able to increase their revenue over time, very few are able to continue compounding at a constant rate for such a long period, let alone at a mind-bending rate of 28% per annum!

Judging solely from the volume of parcels arriving at our place lately, 2020 will likely prove to be yet another year of ~30% revenue growth for Amazon!

Certain other tech businesses have managed grow user numbers rapidly, including those where customers tend to invite new users to the platform, such as DropBox (though to date not all are paying users).

The reality is that few businesses can continue to demonstrate compound growth for very long periods of time, and ultimately a plateau beckons, which – depending on your nature – may be an argument for indexing, sector rotation, or perhaps simply focussing on unearthing those precious tech unicorns.

Land: they’re not making it any more

Folks tend to like the security of real estate because returns tend to be less volatile, and there’s a sense of it being a perpetual investment – like humans, companies have a life cycle, but land can’t easily be moved or destroyed.

Economist and academic Robert Shiller showed that in the U.S. residential real estate prices over the very long term had appreciated only by a modest percentage per annum above the rate of inflation.

This intuitively makes sense, although the leveraged returns from some markets would’ve been better than others.

Land, overall, isn’t a scarce commodity, but in some neighbourhoods it is.

Compound growth in real estate appears most likely to come from assets where there is a scarcity of well-located land, a growing population and demand, and – I believe – inherited wealth which tends to be capitalised into land values.

It seems to me that in peripheral real estate markets where there’s less scarcity of land, and where marginal prices are set by younger or first-time buyers, genuine compound growth over the long term is unlikely to occur (especially as technology and modular construction makes tract or ‘cookie-cutter’ housing more efficient to produce).

Letting it run wild

Housel himself concluded that the potential power of compounding is so big that you can barely wrap your head around it.

Or in the words of Professor Emeritus in Nuclear Physics Albert Bartlett:

“The greatest shortcoming of the human race is our inability to understand the exponential function.”

Which in financial terms roughly translates to: find a strategy which can let compounding run wild for the longest possible period of time…and stick with it!

Start compounding today – it’s about time.