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Your Investments Don't Always Compound in Value: Here's How To Make Sure They Do

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We have all seen the wonders of compound interest.

Which is why it is commonly termed as the ‘8th wonder of the world‘.

And this can also be seen in the graph below.

Extracted from Robert Shiller’s S&P 500 data

It shows the nominal growth of the S&P 500, a prominent US stock market barometer, in the last 150 years.

Whatā€™s interesting about the chart is that the S&P 500ā€™s growth accelerated over time.

Thatā€™s exactly how compounding works.

Nominal growth starts off slow but increases over time.

The chart below of the S&P500 over the last 150 years shows the same thing as above but in logarithmic form.

It gives a clearer picture of theĀ percentageĀ returns of the stock market over the same time frame.

Extracted from Robert Shiller’s S&P 500 data

The log-chart of the S&P 500 over the past 150 years is a fairly straight line up.

What this tells us is that even though the return of US stocks has accelerated nominally, there was a fairly consistent growth in percentage terms over the time studied.

How Do Stocks Compound?

Source: Giphy

This leads us to the next question.

How?

In order to produce a 10% annual return for shareholders, a company that has a market value of $1 million needs to create $100,000 in shareholder value this year.

The next year, in order to compound at the same rate, the company now needs to create $110,000 in shareholder value.

That figure grows exponentially and by year 30, the company now needs to create $1,586,309.30 to keep generating a 10% increase in shareholder value.

On paper, that seems outrageous and highly improbable.

However, based on the historical returns of the stock market, we see that the S&P 500 has indeed managed to achieve this feat.

The reason is that companies can reinvest the capital theyā€™ve earned.

A larger invested capital base can result in larger profits.

As long as they can keep reinvesting their earned capital at a similar rate of return, they can keep compounding shareholder value.

But Here’s the Catch…

Source: Giphy

Although Iā€™ve given an example of how a company can compound shareholder value over time, it really is not that simple.

Not all companies can create more shareholder value every year.

In reality, corporations may find it hard to deploy their new capital at similar rates of return.

Businesses that operate in highly competitive industries or are being disrupted may even face declining profits and are destroying shareholder value each year if they reinvest their capital into the business.

In fact, most of the returns from stock market indexes are due to just a handful of big winners.

In 2014, JP Morgan released aĀ reportĀ on the distribution of stock returns.

The report looked at the ā€œlifetimeā€ price returns of stocks versus the Russell 3000, an index of the biggest 3000 stocks in the US over a 35-year period.

What JP Morgan found was that from 1980 to 2014, the median stock underperformed the Russell 3000 by 54%.

Two-thirds of all stocks underperformed the Russell 3000.

The chart below shows the lifetime returns on individual stocks vs Russell 3000 from 1980 to 2014.

Source: JP Morgan

Moreover, on an absolute return basis and during the same time period, 40% of all stocks had a negative absolute return.

Even stocks within the S&P 500, a proxy for 500 of the largest and most successful US-listed companies, exhibited the same.

There were over 320 S&P 500 deletions from 1980 to 2014 that were a consequence of stocks that failed, were removed due to substantial declines in market value, or were acquired after suffering a decline.

The impressive growth you saw in the S&P 500 earlier was, hence, due to just a relatively small number of what JP Morgan terms ā€œextreme winnersā€.

Which Is Why Diversification Is Key

Source: Giphy

Based on JP Morganā€™s 2014 report, if you picked just one random stock to invest in, you had a 66% chance to underperform the market and a 40% chance to have a negative return.

This is why diversification is key.

If historical returns are anything to go by, diversification is not just safer but also gives you a higher chance to gain exposure to ā€œextreme winnersā€.

Just a tiny exposure to these outperformers can make up for the relative underperformance in many other stocks.

Conclusion

Compounding is a game-changer when it works.

But the reality is that not all stocks compound in value over a long period of time.

Many may actually destroy shareholder value over their lifetime.

A useful quote from Warren Buffet comes to mind:

ā€œTime is the friend of the wonderful business, the enemy of the mediocre.ā€

Given the wide divergence of returns between winners and losers, we canā€™t take compounding for granted.

By diversifying across a basket of stocks with a sound investment framework, or by buying a fund that tracks a broadly-diversified market index, we reduce our downside risk and increase our odds of earning positive returns.


This article first appeared onĀ The Good InvestorsĀ and is part of a content syndication agreement between The Good Investors and Seedly.

TheĀ Good InvestorsĀ is the personal investing blog of two simple guys, Chong Ser Jing and Jeremy Chia, who are passionate about educating Singaporeans about stock market investing.

If you have any questions about this stock and other stocks in general, why not head over to theĀ SeedlyCommunityĀ to discuss them with like-minded individuals?

Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. ā€‹Readers should always do their own due diligence and consider their financial goals before investing in any stock.Ā 

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