How short-term thinking can wreck your long-term investment returns

That’s normal.

And perhaps you’re wondering how you can dodge these risks in your investments?

That’s normal too.

But it may not be helpful.

If your objective is to build long-term wealth, a key factor is your ability to tolerate short-term market swings and remain invested. There is a cost to jumping in and out of the market in response to uncertainty in the world. However, if you stay invested even when emotions run high, you will harness the power of compounding to your advantage.

The cost of responding to short-term market swings

There are always uncertainties to distract the undisciplined investor. Over the course of history, we’ve experienced pandemics, hurricanes, elections, sovereign debt downgrades, terrorist threats, and even a few financial crises, to name a few. Some of these have been more serious than others and yet, despite it all, the stock market has rewarded long-term investors.

A common mistake for investors is allowing the emotional roller coaster of investing to derail their investment plan. Investors who succumb to trying to “time the market” to dodge these risks often end up inflicting significant damage to their portfolios.

The cost of being on the sidelines and missing out on the best days in the market is staggering. If you stayed invested in the U.S. market for the last 20 years, your return would have been a very appealing 9.7% on average, per year. However, if you missed out on only the ten best days over that period, your return would have been cut almost in half, to only 5.5%. To make the point more tangible, if you invested $10,000 in 2003, you would have $63,000 if you stayed fully invested, versus only $29,000 if you missed those best ten days.^[1]

To state the obvious, those are wildly different outcomes determined by only a few missed days.

What’s more, it is quite easy to miss those best days. That’s because they tend to be clustered right near the end of periods of crisis, exactly when emotional-charged investors have the highest chance of being out of the market, trying to dodge the risks. In fact, over our 20-year period above, five of the ten best days happened towards the end of 2008. That was during the global financial crisis, not too long after investment bank Lehman Brothers collapsed. It was a time of great fear and uncertainty, with much temptation to be out of the market. It’s hard to imagine that anyone who jumped out of the market in those dark days would have leaped back in at just the right time to participate in those subsequent best days.

The alternative: harnessing the power of compounding

What’s the difference between the $63,000 and $29,000 scenarios? In the happier scenario, the investor harnesses the power of compounding to increase their wealth exponentially over a long period of time. In the unhappy scenario, the investor’s potential gains were derailed by interrupting the compounding process. Charlie Munger once said that the first rule of compounding is never to interrupt it unnecessarily. Sage advice.

This rule is supported by the math of compounding. Boring, I know, but stick with me!

Simplistically, the future value of your wealth is equal to how much you have today (the present value) times 1 plus your annual rate of return (r) to the power of the number of years you invest (n).^[2]

Future Value = Present Value * (1+r)ⁿ

What’s the most valuable variable in this equation? Each of the three variables (present value, rate of return and years invested) determines the future value. But humans are wired to overemphasize the “r” and underappreciate the “n”. In other words, most investors are highly focused on generating high returns and don’t give much thought to compounding. But that’s a shame, because it’s really in the uninterrupted compounding where the magic happens – “n” (time) is the most important variable. Think of it this way: if you invest one dollar a year and earn 7% per year, it will grow to almost $95 after 30 years and nearly $200 after 40 years.

At Nexus, we are fans of journalist and best-selling author, Morgan Housel. Our colleague John Stevenson wrote about his most recent book here. Housel wrote this crisp summary of what matters most in compounding:

“Compounding doesn’t rely on earning big returns. Merely good returns
sustained uninterrupted for the longest period of time
– especially in times of chaos and havoc – will always win”^[3]

Putting it all together

In the end, we all must accept that uncertainty is part of life. However, you still get to choose whether to adhere to Charlie Munger’s first rule of compounding.

As clients of Nexus, we put the power of compounding to work on your behalf. Our disciplined, long-term-oriented investment philosophy is designed to utilize the potential of compounding to increase your wealth over time. By working with us, you harness the “n” to achieve your financial objectives, and, with a proper wealth plan, you can also extend the years of compounding to include future generations.

Compounding applies at all stages but can be extremely powerful for early investors. In fact, if there are young people in your life, we encourage you to pass along this blog, or another Nexus blog you can find here that discusses how the next generation can harness the power of compounding to their benefit.