As our semester came to an end, my students at Texas Lutheran University reviewed their investment portfolio. Since inception more than sixteen years ago, their portfolio has grown at a rate of 16.16% per year. I commented that the broad stock market, as measured by the S&P 500, grew at a rate of 14.46% per year over the same time frame.
The differential was easy enough to calculate. The TLU portfolio outperformed the market by 1.7 percentage points per year.
However, I asked a follow-up question. “What has been the cumulative effect from outperforming the market by 1.7 points per year?”
The simple math suggests 1.7 times 16 years equals 27.2 extra points. However, we are not discussing simple interest, but rather compound interest which produces an exponential difference. If you don’t deal with compound math on a regular basis, it is rather hard to conceptualize.
Although there were several close guesses, the class was surprised that outperforming the market by a rather small 1.7 points per year for sixteen years resulted in a portfolio that outgrew the market by 229 percentage points! The extra 202 points of performance were due to compounded returns. That is the power of earning interest upon interest.
Obviously, compound interest makes a huge difference in the world of finance. However, the concept of compounding is not limited to just finance. Furthermore, there can be positive as well as negative aspects of compounding.
Sometimes compounding may be health related. If you smoke one cigarette, it probably will not lead to cancer. However, if you smoke three packs a day for 40 years, the compounding effect increases the odds not only for cancer, but a host of other maladies.
Conversely, if you exercise one time, you will derive a modest benefit. However, if you regularly make cardio and weight training part of your daily habit there are compounding effects that can significantly extend and improve your quality of life.
It’s not too hard to find numerous examples of compounded performance throughout the world.
Consider the people who are the best in their field. Whether music, dance, engineering, athletics, business, medicine or law, the people who truly excel did not start out that way. Rather, it began modestly with the stroke of a piano key, one football thrown, one recital, one class, one lab experiment, reading a book, saving a penny, investing a dollar, etc.
Warren Buffett has often quoted the phrase, “The chains of habit are too light to be felt until they are too heavy to be broken.” Those words go hand in hand with the compounding effect in all manners of life. Take one modest step. Be focused and disciplined. Repeat day-in and day-out.
Whether discussing your health, your finances or your reputation, recognize that a compounding effect is hard at work behind the scenes. If you compound wisely for considerable time frames, the benefits become geometrically significant resulting in a massive competitive advantage.
However, if you abuse your finances, career, health or reputation, things will snowball in a negative manner. You will underperform, finances will suffer, careers will stall, or people will fail to trust you.
As such, your action point is to identify easy, yet positive goals for the new year. This may be as simple as saving 10% of your earnings, doing 20 minutes of cardio or reading for 30 minutes. It also might mean limiting negative habits. Cut back on the smokes and alcohol, limit the portions you eat, reduce the random social media scrolling.
Take baby steps. Show up a little bit earlier and stay a bit later. Slowly develop a routine but work with intensity and purpose. Once you knock these out for one day, work on continued improvement and compounded benefit for day two and beyond.
Focusing on little goals sets you up to experience geometric benefits over longer time frames. If you merely say, “I want to be a millionaire tomorrow,” the odds are heavily against you. However, if you save a modest amount of money every paycheck for thirty years, the power of compounding will allow you to implement small decisions with monumental payoffs. Soon, those chains of habit will have become deeply engrained in who you are.
Dave Sather is a Certified Financial Planner™ and CEO of the Sather Financial Group, a fee-only and fiduciary investment management and strategic planning firm.
