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The following is adapted from Invest Like the Best. If you want the best long-term investing results (and who doesn’t?), you have to learn to think like the best investors. And that means mastering the dynamics of risk and return, then using them to your best advantage.
At its heart, it’s simple: risk and return are being addressed appropriately if your returns are compounding positively. Then your account is growing exponentially. They are failing if your returns are not compounding.
Successful investors go a step further. They are able to determine the line between acceptable and unacceptable results. If you want to succeed as an investor, you need to learn how to do that as well and it goes beyond just looking at your returns. Let me show you what I mean.
The Dynamics of Compounded Returns
Compounded returns are significantly impacted both by losses and also by the variability of returns. Understanding the dynamics of compounded returns will help you distinguish between acceptable and unacceptable results.
Simply looking at your return-even if it is spectacular over a three-year period—does not tell you this. For example, you may have high returns for three years, but ignoring high volatility for those three years might spell disaster. Understanding dynamic compound interest will help you see and understand the risk.
In the real world, your returns will go up and down with varying amplitude and frequency. However, when you are compounding effectively, your returns grow exponentially over the long term.
Compounding is where great long-term returns come from, and like the best investors, when you have a deep understanding of this, you’ll have clarity about how to manage risk and return for optimal long-term results. You’ll know which conceptual investment approaches make sense, how to calibrate your investment decisions, and what your assessment metrics are telling you in real-time about your chances of success.
The Benefits of a Low-Risk Approach
As we look more closely at dynamic compounding, bear in mind that the power of compounding only works when you do not lose money. Once you introduce losses, the whole dynamic changes. And because you probably intend to invest money for the next 10, 20, or even 50 years, the gains (or losses) can really add up.
In reality, short-term returns tell you very little or can be completely misleading. When you take dynamic compounding into account, you will see that following a low-risk approach can be a powerful part of what it takes to accumulate higher long-term wealth.
Losses are far more harmful to long-term returns than most investors understand. A loss is asymmetrically worse than the same amount of gain for your long-term wealth accumulation.
In fact, losses in any year, or at any time, can be devastating for an investor’s long-term return. They are disproportionately damaging, as they require disproportionate gains to offset the losses. Even then, no account has been made for the time it took for both the drawdown and the full recovery of capital loss. There was a zero return for that time period. So, a further additional gain is then required to make up for no return over the whole period.
Dynamic Compounding in Action
To see how dynamic compounding works, let’s assume that a modest 4 percent gain per year is the benchmark you’re using. However, what if you (or your financial manager) lose 20 percent in one year? How much return would you have to make in the following year to get back on track with a 4 percent compound rate over the full two-year period?
Let’s work through the math to answer that question. You can use this same method to work through your own gains and losses and better understand where your investments stand.
A 20 percent loss takes the value of 100 down to 80. To return to 100, the manager needs a 25 percent return (100/80 = 1.25). Then the investor would still lose two years of 4 percent compounded return to achieve the benchmark. So, to get back to the benchmark, the manager would need to make 35 percent (1.25 x 1.04 x 1.04 = 1.352) to make up for a 20 percent loss. That’s almost twice what was lost!
That is a tall order for just a year, but if the manager can’t do it, the deficit keeps rising, and the makeup gain gets bigger. The manager is now compounding on a lower amount of capital. The longer it takes to make back the compound returns required, the further behind they’ll get.
Most likely, the loss will never be recovered without excessive risk-taking, which could land the investor in an even deeper hole. Even with just a 10 percent loss, a manager would have to make over 20 percent (100/90 x 1.04 x 1.04) in the following year to make up for it.
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Making Up for Losses
As you can see, losses are devastating to long-term compounded returns; as a rule of thumb, an annual return needs twice the annual gain to make up for the loss. So, a lower-risk investor may, in fact, increase the likelihood of long-term wealth accumulation simply by avoiding that big loss! Are you starting to see why understanding dynamic compounding is so important, and why top investors are so risk-averse?
Investors need to be aware that some levels of loss or drawdown of their account put them in a potentially permanent predicament with regard to achieving an acceptable long-term return, even at a modest 4 percent rate. This means that losses at a certain level effectively constitute a permanent impairment of opportunity for their potential long-term rate of return.
Putting It Into Practice
Very little is more important when it comes to investing than understanding the dynamics of risk and return and how to use dynamic compounding to your best advantage.
Remember, you should be focused on achieving investment success, and you’ll be closer to recognizing that goal if you understand (like top investors do) that a low-risk approach will outperform a high-risk approach in the long term.
For more advice on how to decrease risk, increase return, and succeed in investing, you can find Invest Like the Best on Amazon.