The Wonders of Compound Return

This post is for my dear friend who is heavily into trading penny stocks. Looking for that home run so he can retire early. He has a high tolerance for risk, but I hope this post brings another perspective to his view on risk. It’s also for the DIY investors out there who are seeking alpha or wishing to retire early.

Often while strategizing to reach investment goals, I find myself amazed at the power of compounding even till this day. It really helps remind investors to maintain focus for the long term.

 

The Needle In The Haystack

Digging through penny stocks is like looking for a needle in a haystack.

Why go through the haystack looking for needles when you can sort through the needles themselves and look for the best quality needle?!

 

 

You don’t want to turn old and find yourself still digging inside a haystack, do you?!

You can view the S&P 500 and the Dow indices as piles of needles pre-sorted from the haystack by thousands of investors. They made it easy for us!

Would you dig through the haystack if you knew the probability to consistently succeed in finding a needle in a 5-year period less than 5%?

What if you can easily find great quality needles with a 95% chance success rate? 5% vs 95%?? Why bother digging in the haystack at all?!

The question is, do you really have to take a significant amount of risk to achieve great market beating long term returns?

Let’s start by reminding ourselves not to be naive and mistake past performance as ANY indicator for future returns. That being said, let’s take a look at the power of compounding.

 

 

The Wonders of Compound Return

In random, I have mixed and matched about 15-20 stocks which many investors have considered to be great long-term investments. I studied the historical returns for the many sets of portfolios for nearly 20 years. I modeled out as far as 1950 just to see what number of holdings would be optimal.

I came to my own personal conclusion that 15 or 16 is the ideal sweet spot for my personal investment goal. Everyone’s goals will be different so keep that in mind.

The stocks were chosen mostly from the Dow Index, comprised of companies with some of the most stable businesses, strong balance sheets, reliable cash flows, great management, market power from scale, international presence/diversification and strong business models. These are companies many investors consider as value stocks with sustainable dividend payouts and growth. Great steward companies operating with strong shareholders interest in mind. Many with world class board members helping to keep their businesses adaptive to changing environments to stay relevant for decades. Some go as far as to call them “the boring stocks” because they have more predictable earnings with lower volatility in price moments. These companies didn’t become industry giants for no reason.

 

 

In the course of nearly 20 years, investing $160,000 in these 16 companies would have made you a multi-millionaire. The average annual return rate during the period (CAGR) is 18%! CAGR stands for compound annual growth rate. CAGR provides the averaged annualized return factoring for compounding. What’s more amazing is…

 

 

Factoring for dividends, your total returns climb another 433.4%. CAGR is 19.5%! That’s Warren Buffet type of performance! Make sure those dividends are re-invested to reap the benefits of compounding!

I did throw in some odd balls in there like Apple and Nvidia just for fun and to show what a home-run may look like. However, if you remove the two home-runs out of the equation and add two “boring” names like Proctor & Gamble and Coca Cola, your returns will still result to over a million!

 

 

How risky is individual stock investing? You can have half of those companies from the top go bankrupt (highly unlikely) and you would be fine. In fact, wipe out all the gains from 3M to Chevron and your ending value would be $368,590 which is a 130.3% gain. That’s still about 4% compound annual growth rate!

Even with a -17.1% loss in share price with AT&T, dividend reinvestment’s brought returns up to 116%. Which result to an average annualized return over 20 years at 4%. No home-runs here, but in this case, the power of dividends compounding over time provides a great floor for the investment.

Just for comparison, an investment that mirrors the S&P index during the same period would have resulted in the following.

 

 

Which is still amazing! Considering the amount of diversified risk your taking spread out between 500 companies.

Nothing is guaranteed of course but $10,000 invested in 16 or so companies in what many consider some of the safest stocks to invest in, may make your chances of becoming a millionaire in 20 years quite good!

 

 

Don’t Gamble with Your Future

I have done my fair share of dipping in and out of penny stocks in my life and came to the realization that it resembles playing the game Russian roulette. Trading highly speculative stocks had one big benefit. It taught me precisely the difference between investing, speculating, and gambling. Penny stock trading is gambling.

The problem with gambling your way to building long-term wealth is, the odds of winning are horrible in the long term. You need time to allow capital to grow. Just as a sapling needs time to grow.

Would you place your future in the hands of a small struggling company even for a single day who operates with net losses? Or a company like AT&T who generates billions in profits every year?

“Every trade you make can be viewed as a vote on YOUR future.”

Secure your future by investing in a handful of companies you can rely far into the future.

The rest you can invest in indexes or whatever you like. However, I found over diversification may hinder your long term returns for those seeking alpha. It’s hard to go wrong with the list of Dow Component stocks. Even among the Dow, there will be big winners and some losers. Again! Nothing is guaranteed of course!

The home-runs are probably more likely to be found in the S&P 500 indices or the Nasdaq.

Investing in individual stocks is risky but for those who are dealt the average hand in life like many of us will probably require some home-runs to achieve early financial independence. If you are young, you have the benefit of time. I would encourage you to go against the conventional conservative investment advice and choose some individual quality names to invest in for the long term.

It ultimately depends on one’s risk tolerance but choosing from the right pool of needles may not be as risky as many may assume.

The more you understand your investments, the more you will feel confident in your investment for the long term. The key to investing long term is to understand your investments. It’s that simple. Understanding your investments will prevent you from making irrational decisions during times of volatility.

In fact, the more you understand the business, the more you will feel inclined to buy more when others are selling.

So, make sure to pick some needles before you decide to dig in the haystack! Thanks for reading.