What Billionaires Understand About Compounding

Most investors who have been around the block for a while think they understand compounding. You’ve heard it all before that when portfolio returns compound over time, the growth of a portfolio is exponential. But few investors understand the power of compounding the way billionaires do, especially long term value investors.

To increase the size of your portfolio at retirement, you need to understand it in a way Warren Buffett understands it. When you really understand compounding, you discover that it is much more powerful than simply the exponential growth of a portfolio over time. In fact, when you compare a buy-and-sell with a buy-and-hold strategy, you will almost certainly change the way you trade forever.

Some simple math explains why billionaires understands the power of compounding in a way most people don’t. Let’s take a look:

Imagine a portfolio growing at the rate of 15% per year (lower than what Buffett has historically achieved but still a high rate of return). Assume long-term investments are taxed at 20% and short-term investments are taxed at 30%. Here is what the growth rate looks like for a buy-and-sell portfolio compared to a buy-and-hold portfolio over future decades.

Year Buy And Sell Taxes Buy and Hold Taxes
1 100 100 0
10 272 8.4 352 0
20 804 24.8 1,423 0
30 2380 73.4 5,758 0
40 7038 217.0 23,292 0
50 20,818 641.9 94,231 0
60 61,576 1,898.5 381,217 0

In both the buy-and-sell and buy-and-hold portfolios you can see that exponential gains occur. But look a little deeper at the effect of selling versus holding, and you see that the effect of holding stocks and not selling is to vastly increase the portfolio size over time. And the longer the duration, the greater the gap between the portfolio sizes – despite both compounding at the same rate!

Sixty years later the final result is that even if you paid 20% taxes on your long-term investments, you would still enjoy a portfolio over 6x larger than the one you began with. So, the effect of selling winners frequently and paying taxes on those winners is to create a long-term opportunity cost – a missed opportunity for even more gains.

Of course this does not mean every stock you buy you should hold forever. Far from it. Buffett regularly sells stocks like he did when he offloaded IBM after concerns for its long term prospects. It is better to offload a bad stock then hold it for tax reasons.

This highlights the importance of doing your homework on a company before buying it so that you really can hold it forever more. Before making a purchase, can you answer simple questions like:

  • How fast are revenues growing?
  • How big is the market size?
  • Is the market for the products of the company growing or declining?
  • What is the demand for the company’s products among customers?
  • Is the management stable and aligned with the interests of shareholders?
  • Who are the competitors and are they a serious threat over time?

If you can answer thematic questions like these and still think positively about the stock then you might be onto a winner. If not, then seek out new stocks. For example, you could look to companies with good stock ratings or search for value stocks that may be undervalued.

Some companies like Salesforce and Cypress Semiconductor are famous for rewarding employees with stock options at the expense of shareholders, who get diluted. Does the company you invest your money in operate this way too?

If you don’t know then hold onto that punch card which Warren Buffett advocates; he recommends you think about every company you buy as counting towards one of just twenty stocks you can buy over a lifetime. If you thought about every company you wanted to purchase through that lens, you would probably be very selective about which companies’ shares you buy.

None of this is to say that trading in and out of stocks regularly does not have its merits. If you like to trade and been profitable with tweezer candlestick patterns or Hindenburg Omens, go for it – dive in and out of the stock market with abandon. But as part of an account you are relying upon for retirement, think twice about frequent trading and look to those slow and steady winners that can reward you not only from the returns you earn on them but from the taxes you don’t fork over unnecessarily to the government.


Note: This article was contributed by Financhill.

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Category: Stocks

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