We Don't Understand, Pt. I

November 09, 2022
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You and I have a common flaw. We think linearly. No fault of our own, we were designed that way. Most of the time it’s helpful. When investing, it’s not. 

It makes sense that you and I are linear thinkers. We perceive time linearly. You read the first sentence of this paragraph during one second. Then you read the next in the next second. Time is a straight line. For us, anyway. Linear. Say you need to fill a 50-gallon tub with water, and you have a one-gallon bucket. You pour one bucket in the tub, and you’re 1/50th of the way there. After the second you’re 1/25th. It’s going to take 50 buckets to fill that tub. Better get to work.

But investing isn’t linear. It’s exponential. You don’t know how to think exponentially. You might take offense at that. Hey, you don’t know me. You’re right. I do know you’re human though. So I know you can’t think exponentially. It’s ok, I can’t either. I’ll prove it:

Suppose you have a piece of paper sitting in front of you. It’s thin, right? About 0.1 millimeters. How thick would that piece of paper be if you folded it in half 42 times?

The math is simple. Every time you fold a piece of paper in half, the thickness doubles. After the first fold it’s 0.2 millimeters thick, after the second 0.4 millimeters, and so on.

So how thick after 42 folds?

439,804,651,110 millimeters. About 273,282 miles.

How high would that reach?

To the moon.

Actually, quite a bit farther than the moon. The average distance from the earth to the moon is about 239,000 miles. So that 42nd fold will take you to the moon plus about another 34,000 miles (about 1.4x the circumference of the globe), give or take. 

Of course that also means that the 43rd fold takes you to the moon and back plus some. Each fold the thickness of the paper doubles. Exponential growth.

I know that is accurate. I checked the math. Then I double-checked it. But it still doesn’t make sense to me. Accuracy does not imply comprehensibility. It doesn’t matter whether it makes sense to me. It matters that it’s accurate. Our linear brains register exponential realities as impossibilities.

We would do well to remember that.

The folding-paper-to-the-moon example illustrates the most powerful aspect of compounding isn’t rate of return. It’s time. The Rule of 72 is a handy tool – divide 72 by a given rate of return and that’s how long it will take your money to double. If you earn an 8% annual compound rate of return it will take 9 years for your money to double (72/8 = 9). Much like each fold of the paper doubles its thickness.

We all know Warren Buffett is a great investor. We suspect he’s generated the best returns. He hasn’t. Not even close, actually (google “Jim Simons”). He’s had very good returns. But his secret isn’t returns, it’s time.

That’s hard to believe. You’ve been programmed to believe the secret to investing success is returns. Buffett has managed to generate an average 22% annual rate of return over his career.[i] Very good, but far from the best. Let’s say Buffett started like most people and had $25,000 invested at age 30 and then generated 22% returns for thirty years. At age 60, with three decades of 22% annual returns in the books, he hangs it up and spends his days on the golf course.

His net worth at age 60? Just over $9,700,000.

But Google tells me his net worth is currently $102,000,000,000.

That’s 10,515x greater than $9.7M. Same 22% returns. The difference is time. Buffett started investing at age 10 and is still going at 91. Plenty of professionals have matched or exceeded his annual returns. But no one has been investing for 80 years. At 22% RoR, money doubles every ~3.3 years. That’s given him about 24 doublings. That’s why 97% of his net worth came after his 65th birthday.[ii] It’s also why he’ll be worth about $204,000,000,000 a little over three years from now if he continues earning 22%/yr. Buffett’s secret isn’t his returns. It’s time.

The same dynamic explains why homes are mistaken as great investments. Objectively, they are not.* Home prices have appreciated at about a 4% rate historically.[iii] But you hear stories about people who have grandparents who bought their home for $75,000 50 years ago and just sold it for $500,000. What an amazing investment! Well, that works out to about a 3.87% annual compound rate of return. A bit less than the long-term average for a corporate bond. And that’s before insurance, taxes, maintenance, etc. The value of the home grew so much not because of the annual rate of return but because they held it for 50 years. What other investment do people hold onto for 50 years? Holding onto their home for so long allows people to experience a few more doublings.

Patience is in short supply in our culture, but it’s critically important to investment success. Remember, at 8% annual RoR, money doubles every 9 years. Watching your $10K double to $20K from age 25 to age 34 isn’t that exciting. Watching it double from $1M to $2M from age 65 to 74 is much more fun. I imagine Buffett watching his $100 billion become $200 billion is even more exciting. The later doublings are the most important. But you must allow compounding to work its magic during those early decades to reap the rewards during the later decades. And you must not interrupt it.

Opportunity compounds. It’s true when folding paper and it’s true when investing money. Fold a piece of paper 43 times and it reaches the moon. $100K invested at 8% RoR for 27 years grows to just under $800,000. Three doublings. The last doubling from year 18 to year 27 took you from $400K to $800K. That’s nice. But leave it invested for 99 years and it grows to just over $200,000,000. Yes, that’s two hundred million dollars. 11 doublings. The last one from year 90 to 99 took you from $100M to $200M. That’s borderline incomprehensible. 

Mistakes compound as well.

Anything that interrupts the compounding (doubling) process today has consequences. Not linear consequences. Compound consequences. The most common mistake is getting out of the market because it’s in a temporary decline.** Feels good in the moment. But that’s the moment you’ve reset your compounding clock. This often leads people to lose their last doubling in their life. Their most important one. Lose one doubling and your net worth will only ever be one-half what it would have been. Sacrificing one doubling means sacrificing one-half your future net-worth. Usually not a good decision.

Time is your most valuable resource when building wealth. It’s also fixed. You can’t have more of it. You only have so many doublings. Don’t lose any of them.

Opportunities compound. Mistakes compound. It’s a double-edged sword. 

Sean Cawley, CFP®

*I bet this generates some fun responses! I’m talking about primary residences here, not your rental real estate portfolio.

**You’ve considered that recently, haven’t you?

Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.

Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.

This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.

[i] “The Psychology of Money,” Morgan Housel, pg. 50.

[ii] “The Psychology of Money,” Morgan Housel, pg. 49. 

[iii] YCharts, Case-Shiller Home Price Index: National Fundamental Chart, 01/01/1987 – 12/21/2021