FV=PV*(1+r)^t is the formula for what Einstein called the Eighth Wonder of the World, namely the power of compound interest. Time is the most important driver of this wealth building equation, but it can also be the most difficult part for real investors to harness because of the fact that we are ourselves bounded by its constraints. As seemingly important information (news headlines or price changes in our portfolios) is constantly arriving, there can be a strong urge to periodically change course, and therefore possibly press reset on the all-important time variable.
We’re fairly certain Tom Petty wasn’t thinking about investing while he sang “The Waiting”, but he could have been. In fact, rather than “seeing a card” every day, as investors, we may only “see a card” that actually matters every few months. Because if this, it is critically important that we have confidence in our strategy can therefore wait patiently, and without undue concern. If we aren’t able to stick with our plan through down periods, we simply can’t expect to achieve our long term investment goals.
Research shows that the returns actually achieved by many investors fail to measure up what might have been expected given the options available to them (and the known ex-post-facto returns of those investment options). Perhaps the best known study is done by DALBAR, Inc. and updated each year. Some noteworthy findings from the 2015 summary:
• The 20-year annualized broad market equity return exceeded the 20-year annualized return earned by the average equity investor by almost a 2:1 margin (9.85% vs 4.66%)
• In 2014 both the broader stock and bond markets outperformed the average stock and average bond investor by factors exceeding 2:1
• This under-performance of the average investor occurred in spite of him/her “guessing right” 8 of 12 months (as judged by subsequent months’ performance)
These performance discrepancies are mostly due to asset class selection and the timing of the buys and sells of the asset classes. Many investors inadvertently end up with a start-stop-start-stop approach. Even if this is unintended, and even if the starts and stops only happen on just a very few occasions, the damage done to overall returns can be substantial.
Despite being generally “right” about immediate market direction, investors as a whole under-perform the broad market indexes because being out of the market earns nothing, and also because by the time a move feels right, it is often almost over. The magnitude of market impact for unexpected events exceeds the magnitude of market impact for expected events by a substantial margin. Many investors fail to account for these surprises (which we know are bound to happen, but for which we don’t know the timing) in their investment plan.
Given the meager actual performance of intelligent and motivated people, what should we do to place the odds back in our favor? In the simplest possible terms, what matters most is sticking with a reasonable investing strategy for an extended period of time. Three questions:
Question: What is a reasonable investing strategy?
Answer: A reasonable investing strategy holds different types of investments (diversification) and doesn’t try to time the market by repeatedly jumping in and out of investments. A reasonable strategy can also be biased toward more attractive values.
Question: How can we make sure we stick with the strategy?
Answer: We should our portfolio risk constraints to a level appropriate with our individual situations and personalities. (This is why the risk profile we cover at the beginning of the process is so important, it directly influences the likelihood that we “hang in there” without too much teeth gnashing.)
Question: How long do we have to wait?
Answer: That is a question that requires a statistical answer. One way is to note that many market cycles occur over 7-10 year periods (or less), so it is likely that within that period of time, our strategy and discipline will be rewarded. A longer answer is that it depends on the stochastic nature of the market process and the degree of certainty we require in our test. For example, how many times would we need to toss a coin before we can be sure we will have 50% heads and 50% tails?
In summary, as investors, we can maximize our probability of achieving good long-term returns by picking a good plan, and then by sticking to the plan, and allowing compound interest to work in our favor. While we can’t be certain about the exact future outcomes, due to the nature of risk, we can be confident about process and the overall probability of a positive outcome.