How the power of compounding applies not only to wealth, but influence, expertise, and creativity. How non-monetary investments can lead to greater monetary wealth and satisfaction.
In this episode you’ll learn:
- Why the rule of 72 and the power of compounding are hindered by portfolio losses.
- Why the sequence of returns impacts investment performance, but also our expectations.
- How what we experience in the world is made up of separate glimpses and events.
- What are non-monetary things that compound with time and why there are no short-cuts.
- How to focus our attention on things that compound.
- How non-monetary investments of our time can increase our monetary wealth.
Show Notes
The Rule of 72 Defined by Caroline Banton—Investopedia
What Yogi Berra Would Have Said About This Bull Market By Jason Zweig—The Wall Street Journal
How to Do Nothing: Resisting the Attention Economy—by Jenny Odell
Pearblossom Hwy., 11 – 18th April 1986, #2 by David Hockney
Truman Capote, The Art of Fiction No. 17 Interview by Pati Hill–the Paris Review
Kapital – History, Philosophy, and Iconic Products by James Smith—Heddels
The Perfect Fit Shopping in Tokyo. By David Sedaris—The New Yorker
The Unknown Craftsman: A Japanese Insight into Beauty by Soetsu Yanagi, adapted by Bernard Leach
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Episode Summary
We have all been taught to save our money so that it compounds over time as an investment for our future, but what if not just monetary wealth compounds? Is money a worthy investment of all of our time? How do our personal experiences influence our outlook on the future of our wealth—monetary and otherwise? In this episode of Money For the Rest of Us, David encourages listeners to invest not only with their money but with their time and creativity as well.
Be wary of simplified compounding schemes—it takes time for money to compound
“Save early. Save often.” While that may be a useful key to future wealth, is it really that simple? The rule of 72 says that if you divide the number 72 by your annual rate of return, the answer is how long it will take for your money to double. David unpacks this and other media-endorsed, simplified rules of compounding. Yes, your money should grow over time by means of compounding interest, but most schemes assume rates of return and annual savings at higher rates than most have or practice. The power of compounding only works if the individual doesn’t lose money in the process. If he or she does lose money, then it takes an exuberant amount to climb back up to even. For instance, if you have $100,00 invested in the market, and you lose 50%, then it will require you to gain 100% of it back again. Depending on how or if you have diversified your portfolio, getting back to even could take years.
The sequence of returns also matters in how your compounding scheme works out. If you invest $100,000, the end result will be drastically different based on if you saw an initial rise of 100% followed by a fall of 50% vs. an initial fall of 99%, followed by a 50% rise. We can’t choose the sequence. We don’t know what will happen. But the future is certainly influenced by what passes through time in the present.
Life experiences color our perception of what will come next
We remember what we have seen, heard, and experienced. Our perception of the world— and money—is influenced by our memories of the past. What we expect to happen is guided by what we have previously experienced. Just as the sequence of events matters in the market, it matters in our lives as well. David shares his experience as a money manager, walking through the Asian emerging markets crisis and then through the internet bubble in the early 2000s. His outlook on the future of investing was influenced by the sequence of those events. Who can say what his outlook would have been had the events of his career been mixed up? We are changed by our experiences, but we can never know what our future experiences will be. We only have the option to live life—through life and time as we garner experiences.
Not just wealth compounds—influence, expertise, and polish can also be compounded
The British artist David Hockney saw painting as a way to converse with and experience time—even after the moment depicted had fled. The time that the artist put into the painting could be seen and felt by those viewing it. It did not just depict one moment—but several. He despised photography because he saw it as a cheap way to freeze a moment in time. There was no passage through time—simply the frozen memory of a single instant. Hockney later went on to create a piece of artwork made out of hundreds of photographs, having found a way to create living art through many frozen moments. Not just monetary wealth compounds. Some things in life simply need time to mature—to become alive and influential. One’s influence, for instance, is not built upon a purchase—even though some try to buy themselves fame. It is created slowly, by wading through time and life. It compounds and becomes more full and rich with time.
Expertise or polish in a certain skill is also compounded through the passage of time. Wisdom and judgment are formed as we grow in our knowledge of the world and our skills in practiced areas of life. As we learn new things, our mental, physical, and emotional capacity grow as we inventory new ways of seeing and creating. Taking the time to polish or perfect a skill or an art form takes time. It takes a willingness to change and make better. David uses the example of publishing. It takes time to write a book, revise it, and publish it. You can’t rush passage through time. There are no shortcuts. Only the path through.
Learning to invest time in our creative side will lead to a different kind of wealth
David encourages listeners to invest in activities, things, skills, and knowledge that will compound over time. Yes, we should invest our money with the hopes that it will compound, but there are many other ways in which we can invest our time, energy, and faculties to make us better people—individuals whose wisdom, expertise, and influence will compound as we walk through time. Age will come, of course, but that is not something to avoid. A certain type of liberation and freedom is found when we invest ourselves in compounding interests, passions, and skills. We change, certainly. Time changes things. It strengthens our character—if we use it wisely.
Episode Chronology
- [0:20] The dangers of oversimplified compounding schemes.
- [4:30] Our experiences influence what we expect to happen.
- [7:57] A picture made up of pictures taken through time.
- [11:26] There are no shortcuts to forming experience.
- [15:05] Influence is created by passing through time—not by purchasing it.
- [18:32] Expertise, polish, perfection are all built by passing through time.
- [19:41] Taking the time to invest in creative work through time.
- [22:01] Time brings age—and that is okay.
- [23:11] Passing through time brings wisdom and experience.
Transcript
Welcome to Money for the Rest of Us! This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 257; it’s titled “It’s Not Just Wealth that Compounds with time—The Power of Compounding.”
Save early, save often. The rule of 72. These are ways to illustrate that more time investing can lead to greater wealth. To be frank, though, the rule of 72 is supposed to be simple, but I always have to look up what it means. It means that if you divide 72 by your annual rate of return, that’s roughly how long it will take to double your money. If you have the fortune to earn 10% per year, investing, we divide 72 by 10. That means we can double our money in 7.2 years. Rule of 72, I don’t find it terribly intuitive. Nor terribly useful.
Compounding isn’t quite that simple
There’s a recent article by Lance Roberts titled, “Everything You’re Being Told About Saving and Investing is Wrong.” And he points out that the media loves to share some of these simple savings. He gives an example that was on CNBC. Here’s the quote: “If you start at age 23 for instance, you only have to save about $14 a day to be a millionaire by the age of 67.” That’s assuming a 6% average annual investment return. There was another example from Investor’s Business Daily: “If you’re earning $75,000 by age 40, you need 2.4 times your income or $180,000 in retirement savings. Simple as that.” That assumes a 10% annual savings rate and a 6% annual rate of return.
But it isn’t quite that simple. Robert says “The power of compounding only works when you do not lose money.” And that’s because after you have some losses, you’re trying to follow the rule of 72, and it assumes you earned the same return every year. We don’t earn the same return every year typically. And if we lose money, we have to earn that money back. If you lose 50% in the market, you need a 100% return to get back to even. So you have $100,000 and you lose half; it goes down to $50,000, gain 100%, you’re back to $100,000. But if you lose 60%, you have to gain 150% in order to get back to even. Now if you only lose 20%, you need to earn 25% to get back to even.
This is important in light of our discussion on having 100% in stocks. You have to be prepared to lose 50-60% if you’re going to be 100% stocks. Which means you need to be ready to earn 100-150% in order to make up those losses. And that can take time—3,4,5 years or more.
The other thing about sort of these simple, compounding platitudes is the sequence of returns matters. The order in which the returns come. If you have $100,000 and it goes up 100%, then you have $200,000. Then if you lose 50%, you have $100,000. If we contrast that, if you have $100,000 and lose 50%, then you’re down to $50,000, just like the earlier example. And then if you gain 100%, you’re back to $100,000.
A 100% gain, followed by a 50% loss, leaves you basically at the same point as if you lose 50% and then gain 100%. But what if you have $100,000 and lose 100%, to start with, then you’re ruined. Or, let’s say you have $100,000 and you lose 99%. Now you’re down to $1,000. Does it matter, because if you’re 50% on top of that, then you’re up $1,500. So the sequence of returns matters. And it matters in terms of our experience.
Our experiences influence what we expect to happen
There was an article by Jason Zweig in the Wall Street Journal titled, “What Yogi Berra Would Have Said About This Bull Market.” I discussed this article this week in the Money With Friends Podcast with Joe Saul-Sehy. In that article, Zwieg mentions that “what you expect depends on what you have experienced.” And he alluded to a memory bank, that we remember our experiences. And we remember the sequence of returns that we experienced, and that reflects our expectations of the market.
I became an investment advisor in 1995. I remember the U.S. stock market went up 37% in 1995. The first crisis I remember was the Asian emerging markets crisis in 1997. I remember it because I had a client invested in an Asian emerging markets stock fund because they didn’t want to go into a broad-based emerging markets fund because this particular client remembered the Mexican peso crisis. We probably shouldn’t have been recommending emerging markets funds at all based on their valuations, but we did. I remember the Internet bubble, and working clients through that. I remember 2003-2007 as being a great time to invest. And I remember the Great Financial Crisis and the impact that that had, shepherding client assets through that.
But that’s just one pattern of time. There’s this concept of resampling. What if the crisis had happened first, followed by the Internet bubble? Would my perception be different? Zweig points out, “after 10 bullish years in stocks, some younger investors have no memory of losing serious amounts of money. That could make them think it can’t happen.” So we change with our experiences, our experience in the market. The order of those experiences in the market.
There’s a book called The End of Theory by Richard Bookstaber and there’s a great quote from that book. He says. “We humans move from experience to experience. We learn; we invent; we create. We cannot already know what we will experience, what we will learn, invent, or create. It is the nature of humanity to harbor radical uncertainty. Fundamentally, we don’t know where we are going, and we don’t know who we will be when we get there. We essentially must live out our lives to see where they will go.
There is no formula that allows us to fast forward to find out what the result will be. The world cannot be solved, it has to be lived.”
We live through time. We’re changed by time. Yet, our portfolios are impacted by what happens through time. There is some compounding. Yes, losses can make a difference and we have to recover those losses. But, there’s other things that live through time and that grow and compound through time. I’ll share some of those in this episode.
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