Credit: Shutterstock photoThe power of compounding may be one of the most important principles for investors, but also appears to be one of the most misunderstood.
Compounding is known as the eighth wonder of the world, but there has been a growing chorus of professional investors who claim that most stock market participants are no longer interested in long-term investing and the long-term benefits of compounding.
Compounding: What Is it Good For?
Most of the worldAAAs most revered investors have made their fortunes over several decades and they would not have been able to do this without compounding.
Today, stock market participants are becoming increasingly focused on the short-term. Hedge funds report results quarterly, or even monthly, companies report quarterly and most asset managers are judged on only a few years of performance, which is hardly enough time to judge their skill accurately when bull/bear markets can last for more than five years.
Understanding how the power of compounding can help improve your returns through both the effect it has on your portfolio and how it can help you reduce tax liabilities is the single most important key to long-term wealth creation.
My favorite study, which shows how important compounding and by and hold investing is for the average investor, comes from a document ( Timeless Wisdom for Creating Long-Term Wealth ) that has been put together by Davis Advisors, the $40 billion mutual fund powerhouse founded by Shelby Davis -- the son of Shelby Cullom Davis (you can read more about Shelby Cullom Davis here ).
The chart below, which is take from the document, illustrates how four different investor reactions to a market correction can impact returns.
Four hypothetical investors each invested $10,000 in the market from January 1, 1972, to December 31, 2013, but all four investors acted differently during the 1973 to 1974 bear market.
The Nervous Investor sold out and went to cash. The Market Timer sold out but moved back into stocks on January 1, 1983, at the beginning of a historic bull market. The Buy and Hold Investor held steady throughout the period. And lastly, the Opportunistic Investor realized that the bear market had created opportunities and contributed an additional $10,000 to his original investment on January 1, 1975.
This chart shows more than just the benefits of compounding. It also highlights the stupidity of market timing. The chart clearly shows that trying to time the market will severely impact your long-term returns -- there is plenty of other research on the topic of market timing out there that reaches the same conclusion.
Compounding will revolutionize your investment returns and one investor who understood the benefits of compounding was traditional value investor Walter Schloss.
Walter Schloss and the Power of Compounding
Walter Schloss, or cigar butt Schloss, was one of the few value investors who continued to follow Benjamin GrahamAAAs teachings right up until his death in 2012. While the rest of the market moved on to more exotic trading strategies, Schloss continued to buy
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
