Compounding is magical only over the long term
I recently looked at how buying stock market index or tracker funds could ruin your wealth prospects because they make you feel safe investing in what is most likely the top, or near to the top, of a long bull market. If I am right, then years of disappointment and investment underperformance will lie ahead as stocks revalue back to reflect a more realistic long-term rate of return on money.
But some readers have quite rightly asked me: “OK, if we agree with you on that, then what do we do instead?”
It is a fair question. But just to underline where the index funds get it wrong: basically you will never become rich as an investor by going for maximum diversification and waiting for the tide of economic growth to raise all boats.
Rather you have to do the exact opposite: cleverly select a few investment opportunities that are set to do really well whatever the financial weather, and stick with them for a long time so that the mathematical power of compounding will work in your favour.
My old friend Chris Mayer has got this right and that’s why he is the doyen of American investment newsletter writers these days.
We first met back in early 2009 when he contacted me after reading my book: Opportunity Dubai: How to make a Fortune in the Middle East. He came to Dubai with his publisher Addison Wiggin in the midst of the global financial crisis and the property slump. I was delighted to meet them. And they subsequently invited me to address the 1,000-plus delegates at their annual conference in Vancouver about my experience of business and journalism in the UAE.
Mayer quoted me extensively in his book about global investment opportunities: World Right Side Up: Investing Across Six Continents, which sold much better than mine.
His then top Dubai stock selection, Emaar Properties, went on to produce stellar price performance even though this book was published well after the strong economic recovery in Dubai was obvious and the city’s reputation restored.
Most recently, he has been working as the chief investment officer for American financial publisher Bill Bonner of Agora Financial. His latest tome: 100 Baggers, a study of stocks that returned 100-to-1 from 1962 to 2015, drills down into what exactly is behind shares that offer huge outperformance. What emerges is the very reverse of the idea of an index averaging out your returns over time.
Warren Buffett’s Berkshire Hathaway is the standout winner. It has risen more than 18,000-fold since the ‘60s: US$10,000 invested in 1965 is worth $180 million today, as opposed to just $1.1m if invested in a tracker index fund following the S&P 500.
Berkshire is also an investment vehicle rather than a company in a single sector, so its own success is very much an insight into how to maximise investment returns. Mayer highlights two very clear conclusions: “First you have to be concentrated. You have to focus on your best ideas. You can’t own a lot of stocks that just dilute your returns.
“Warren Buffett did not hesitate to bet big. His largest position would frequently be one-third, or more, of his portfolio. Often, his portfolio would be no more than five positions.”
His other crucial insight is that you need to hold these well-selected investments for a long time to maximise the incredible power of compounding, a mathematical phenomenon. Mayer tells an old legend to explain this: “There was once a king who wanted to repay a local sage for saving his daughter. He asked to be paid a grain of rice a day, doubled every day. Thus on the first day he would get one grain of rice. On the second day, two. On the third day, four. And so on.
“The king agreed and in a month, the king’s granaries were empty. He owed the sage over 1 billion grains of rice on the 30th day.”
Actually the power of such compounding works best at the final stages of a long-term investment as the upward curve becomes exponential.
But how do you spot the next Warren Buffett and his Berkshire Hathaway? That’s the service Mayer is now offering his high-paying subscribers in his Bonner Private Portfolio. And he did get the Dubai recovery right as a foreign investor when most local insiders had given up.
The downside is that at $5,000 a year for subscription (the first year comes at an introductory rate of $3,000) it is probably the most highly-priced investment newsletter in the industry, though that is of course no guarantee of success either. If it were that easy we could all be as rich as Mr Buffett.
Peter Cooper has been a Gulf financial writer for 21 years
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Updated: June 9, 2017 04:00 AM