Last Man Standing
It is only appropriate that we end the year with a piece on compounding and that it happens to be from Morgan Housel makes it that much more worthwhile. Like much of Housel’s stuff, this one too reiterates a known insight but come at differently to drive home the point. The point Housel is trying to make here is that high percentage returns are not as important as healthy returns but one that is sustainable. This is because our expected outcome from investing is to fulfil our financial goals which require absolute dollars and not percentages. And absolute dollars can be maximised by combining time and return, allowing compounding to work its magic.
He starts off with Jeff Bezos’ focus on absolute cash profits as opposed to profit margins for Amazon:
“Jeff Bezos had a different view: Margins don’t matter. Dollars do. A huge business with low margins was preferable to the opposite. He explained in 2014:
“Margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize.
Free cash flow [is] something that investors can spend. Investors can’t spend percentage margins … What matters always is dollar margins: the actual dollar amount. Companies are valued not on their margins, but on how many dollars they actually make.”
Then he corelates the same concept to investing:
“Everything worthwhile in investing comes from compounding. Compounding is the whole secret sauce, the rocket fuel, that creates fortunes.
And compounding is just returns leveraged with time.
Earning a 20% return in one year is neat. Doing it for three years is cool. Earning 20% per year for 30 years creates something so extraordinary it’s hard to fathom. Time is the investing factor that separates, “Hey, nice work,” from “Wait, what? Are you serious?”
The time component of compounding is why 99% of Warren Buffett’s net worth came after his 50th birthday, and 97% came after he turned 65.
Yes, he’s a good investor. But a lot of people are good investors.
Buffett’s secret is that he’s been a good investor for 80 years. His secret is time. Most investing secrets are.
Once you accept that compounding is where the magic happens, and realize how critical time is to compounding, the most important question to answer as an investor is not, “How can I earn the highest returns?” It’s, “What are the best returns I can sustain for the longest period of time?”
That’s how you maximize wealth.
And the most important point is that the best returns you can earn for the longest period of time are rarely the highest returns in any given year, or even decade.
Charlie Munger says “the first rule of compounding is to never interrupt it unnecessarily.””
Don’t miss the video at the end of the blog.