The Snowball Effect
By Chris Lafayette, CFA & Portfolio Manager
It was an 11th grade Investing class at Burlington High School where I was first introduced to the magic of compounding returns. Our teacher, Mr. McGrath, demonstrated how modest savings early in life, growing at historical rates of stock market returns, would make us all millionaires with the benefit of time. This was naturally fascinating and many of us immediately started buying stocks, but as luck would have it, my junior year of high school coincided with the end of the go-go 1990s. The subsequent Dotcom bust saw a 49% peak to trough decline in United States equity markets and left few of us as stock market enthusiasts.
However, because of a love of statistics, and an innate curiosity around all things business, I endeavored to better understand what drove these mysterious markets. Flash forward to today and I’ve spent the past fourteen years managing assets, but I am still constantly reminded that the practice of compounding money is more difficult than the theory.
Stocks are a risk asset. At almost any given time, I like to assume there is the risk that stocks could go down 50% from where they are. But for taking this risk, investors have historically been compensated with higher returns. The S&P 500 has compounded at 10.5% annually since inception. Double digit returns sound great when compared to “risk-free” assets, like a 10-year United States Treasury, yielding just under 2% today. However, no one can tell you what a stock portfolio will be worth tomorrow, and an investor must be willing to sustain significant short term volatility, to achieve long term gains.
The person most often quoted when looking to decipher the stock market’s gyrations is Warren Buffett. Appealing to my contrarian nature, my personal favorite is, “Be fearful when others are greedy and greedy when others are fearful.” If you read Buffett’s biography by Alice Schroeder, The Snowball, it details how his acceptance of stock market volatility, and the ability to take advantage of it, took him from humble beginnings to one of the world’s wealthiest individuals.
Another thing that Buffett is quick to point out is that you can reduce the likelihood of experiencing losses the longer you stay invested in the market. Looking at the S&P 500 average annual returns for trailing 10-year periods starting in 1935, only 4 of 86 times would an individual have lost money if able to stay invested for the full 10 years. Furthermore, those losses were very modest.
As we well know, this history encompasses numerous international conflicts, periods of incredibly high inflation, countless political and policy transitions, numerous interest rate environments, and even a world war. Needless to say, the stock market has shown a tremendous ability to endure substantial turmoil in its long-term march higher.
Still, news headlines suggest investing is a timing game, and we are led to believe that there are times of greater risk in the market and times of less risk. It is natural for investors to want to avoid risk, so it would seem logical to sell when the risk is greater. There is no question that the market dislikes uncertainty, but if we can use history as an example, and assume that the problem de jour will eventually find a resolution, then market pull backs are actually an opportunity to buy assets at lower prices to benefit from long-term results.
The tragic events unfolding today in Ukraine have been portrayed as introducing a higher element of risk to the stock market. International indexes with the most direct exposure to Russia and the Ukraine have less than 2% and 0.1% respectively, but there are real impacts on commodities. Russia is a significant exporter of fossil fuels and wheat, and price increases could impact the Federal Reserve’s decision to raise interest rates, introducing second order risk.
While these risks are real, periods of high inflation, or escalating tensions between global superpowers, are not unprecedented and it doesn’t take a long walk through history to find parallel situations. Then, like today, the manifestation of these risks resulted in large swings in stock markets. But as the chart below shows, large daily stock market declines have often preceded the largest daily percentage gains in history.
If a strategy of de-risking a portfolio meant exiting stocks after prices declined sharply, we can see that historically you are apt to miss out on days of rapid recovery. The data on missing the biggest increases in the market is devastating to compounding gains.
Analysis by Bank of America suggests that missing the 10 biggest daily gains in the stock market each decade, reduced cumulative returns over 10 years from 105% to just 36% since 1930.
How do we sleep at night knowing that we must sustain periods of significant loss to reap the compounding benefits that stocks provide? On this, my personal approach mirrors that of the investment team at Trust Company of Vermont, which is why I am so excited to have joined forces. Our philosophy is to own high quality, cash producing companies, that are in good financial condition such that they can navigate negative events and live to reap the rewards of an eventual recovery.
Again, this sounds simple, but no one likes looking at the value of their portfolio declining. The practice of drowning out headlines and having a long-term mindset is more often spoken of, than it is adhered to. Despite the compelling proposition Mr. McGrath offered more than twenty years ago about compounding your way to financial freedom, not everyone will be able to withstand the temptation to “avoid losses.” But for those that can accept the volatility, and view it not as a risk, but rather the reason you will be rewarded, the benefits of compounding returns are just as available today as they were when first explained to me many years ago.