Charlie Munger has loads of great quotes, but this one is a standout:
The first rule of compounding: never interrupt it unnecessarily
Charlie Munger
The maths behind compounding is easy enough, but the intuition is anything but.
If you can find an investment that compounds at 20% per annum, the gain you make in year 10 is greater than the total amount you started with and the total value has grown more than six-fold.
Sure, investments like this are uncommon (although not as rare as you might think), but you only need one or two to make all the difference over your investing career — even if the other decisions you make are truly awful
In a recent podcast, investor and author Gautam Baid put it this way:
“Compounding is convex on the upside and concave on the downside. Positive asymmetry. Few understand this but the day you do, it will change your investing perspective forever.”
The example he gave was an investor that bought one share that compounded at 26%pa and another that compounded at negative 26%pa. You could forgive someone for assuming the end result is a wash, but after 10 years you’d actually have compounded your money at over 17%pa.
What’s wild is that even if you’re wrong 75% of the time, you can still do well with just one big winner.
For instance, if our investor splits their money across four investments, one of which compounds at 26%pa, and the other three lose 26%pa, you still come out with a 10% average annual return after a decade.
But, as Charlie says, this only happens if you do NOT interrupt the compounding process.
Gautam illustrates this by assuming that our investor trims their winning position by 10% each year. In the first example, the average annual return drops from over 17%pa to just 8%pa.
Over a decade, the dollar value difference is gigantic. Obviously, if you trim more, or your strike rate is lower, the difference becomes even more extreme.
All of this is easier said than done, of course. The trouble is that, in these types of examples, you quickly find yourself with position weightings that would give any right-thinking portfolio manager a heart attack.
In our examples, it only takes a few years before your winning stock becomes close to 90% of your total portfolio. Could you really have enough conviction to hold so much of your wealth in just one basket?
As someone who repeatedly sold down their holding in ProMedicus (ASX:PME) — a position that would be otherwise closing in on a 100-bagger at this point — I (try to) find some solace in this. And I try to remind myself that had I not sold other “winners”, I’d be in a far worse situation now — selling down my Pointerra (ASX:3DP) shares as they went from 4c to 90c was absolutely the right thing to do.
So things won’t ever be as clear cut in the real world. But the point here remains valid.
Specifically, don’t sell down your winners just because you’re sitting on a profit — even a large one. Yes, by all means trim back your position if the price is just plain silly, and not justified by genuine and significant improvements in the underlying business.
But if you’re seeing strong sales traction for a business that has a significant market opportunity, is able to self-fund growth AND generate good free cash flows along the way, you want to think very, VERY carefully about locking in any profits.
It’ll feel good at the time, but it could be something you later regret.
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