Fold it once or twice and it will return a thousand folds of bucks
There's no doubt about it, the dynamism of time is a blessing and a curse. It's a blessing because if we had to experience everything it has in store for us one second at a time, we'd be lost. It's a curse because with all of our days limited, we can't stop and appreciate what is happening around us as often as we might want to.
That said, when someone does take the time to stop and smell the roses (or take in the sunset or appreciate that last grandparent hug) they usually regret not having done so sooner. That same sentiment almost always applies when you make an investment wisely for your future with our help here on _______ (the blog post title).
The main reason most people don't appreciate their investment opportunities is that they fail to recognize the value of compounding. In the words of Benjamin Graham:
"In other words, to get a desirable return on one's money over a period of years, it is not necessary to invest in individual securities that pay off at varying rates. [It] is only necessary to invest in pooled securities that pay off at a steady rate."
On top of the fact you can't time a market or predict when an investment will pay off, there are external factors (e.g. changes in laws and regulations, changing tastes, etc. that can change the value of an investment over time). Even if you "buy cheap and sell dear" (which is the investing mantra that has been bandied about), you are only guaranteed to make back your initial investment (minus any fees) if you know the right market to invest in.
In essence, much of the investing world works on a principle known as compounding. I'm going to explain how it works and why we use a certain mathematical formula in pursuit of our investments.
To start, let's define some basic terms as we enter this discussion. The term "return" refers to any profit brought about by an investment or sale of a security. The return is measured in dollar amount and Q (for "quantity") as we'll commonly say.
The term "time" refers to a person's duration of life. Some people are fortunate enough to live a long time and make out with more money (on average), some are fated to die with less (on average too).
The term "risk" refers to the possibility of losing the amount one invested. It's the best-case scenario these days because stocks historically have returned over 10%, but that is if they don't get hit by an asteroid or a recession. A stock can also drop into oblivion with no explanation if something goes awry in its industry. The risk for a stock is measured by the R-squared.
The term "return" will also be referred to as a "return above risk". This is because as we'll see, returns are usually above the market's average return (based on historical data and normal randomness). Returns above risk are measured by the R-square.
Now that we have our terms defined, let's look at some example returns and risks for an investment in S&P 500 index. A S&P 500 index, which measures the performance of 500 stocks in the US stock market, has historically returned around 10% with an average of 2% annually (which makes it sound better than it actually is).
Let's look at an example of an investment in a particular year for the S&P 500. This is going to be the risk and the return for one year (2014):
Risk: 1.5%
Return: 11%
Risk-adjusted return: 10.5% (R-squared: 90%)
So if we compare our risk to other investments, like treasury bonds or gold, they're still in our favor. But what if we didn't think about risk and just invested in the market? Well, that would have been nice but holds us back from being smart investors. That's because if we did not compare the expected return to the risk (as we should be), our time horizon could have been longer than we imagined.
There are times when an investment is less risky than other investments but still yields lower returns. As for the reverse, sometimes an investment doesn't seem risky but ends up being more profitable than other investments.
But this is where compounding comes in. Compounding refers to earning profit on the initial amount of profit you already made. The reason compounding interests us is that when we make a return above risk, we don't spend it immediately. We continue to let it grow so that when we need it in the future, it will be there to satisfy our needs (the power of compounding).
The power of compounding really comes into play when you're making good returns and that's why I started this article off with an example of returns and risks so you could see how time works with risk and return.
However, unfortunately, some investors don't reason like this. For example, a person may think that investing in the stock market is risky but will yield a lot of money if only the market continues to go up. That's why some people choose to invest in the stock market and still stop at the ATM (or run out of their money) when it is down or if they make bad decisions.
We've all been there: "I worked hard for this money" and we feel bad about being broke because we thought we had made a major purchase but "the market's down" or a person did something rash (or even took on too much risk).
Getting back to the topic at hand, let's look at same example but with a few changes. We're going to use different numbers so we can compare them (whether they be historical or hypothetical).
Risk: 1.5% (adjusted from previous example)
Return: 10% (adjusted from previous example)
Risk-adjusted return: 9.5% (R-squared: 82%)
This is just the average for this year so if you took all of your money in the S&P 500 market, you wouldn't fare as well as someone who invested in another asset like gold or treasury bonds and just made sure he/she never spent it all in a given year.
Now let's look at the total return from 2011 (including interest/dividends earned on investments) on a risk-adjusted basis. This will help us see how much money we made after a year and compare these returns to stocks which have higher risk than treasury bonds or gold. These returns include treasury bonds, S&P 500, gold, and real estate:
Risk-adjusted return: 4.
Conclusion: S&P 500 wasn't bad. It was just not quite as lucrative as other investments that returned less risk.
And what if you thought a 10% return was not risky enough? What if you thought 10% in treasury bonds or gold would be more of a gamble? Well, then it's time to look at historical data on how much investment has produced in the stock market. You see, if you invest often enough (I'm going to explain how later), you will come out ahead even if your returns are not as high as an individual stock's returns (assuming it is risky enough).