• Brett Schafer

The Three Levels of Compounding

Someone on fintwit once said:

“Compounding is the highest form of living”

I can’t remember who exactly said it, and it has probably been repeated many times before, but for some reason, that quote has stuck with me. I probably think about it once a week.

The definition of compounding money is “the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.” But compounding doesn’t just apply to money. Replace “asset” with “friendship” and “earnings” with “quality time” or “experiences” and you’ve defined how to build lasting relationships. The same can be said for fitness, nutrition, cooking, sports, any “game” that we play in life can be improved upon by compounding our prior knowledge and experiences.

But since I write about investing, and think I have some ever so minor perspective about it, this post is going to be about compounding money and building long-term wealth (the adjacencies, I think, are pretty clear though). My loose framework is as follows, starting with the basics and moving upward:

  1. Invest my money with an indefinite time horizon.

  2. Find companies that can reinvest capital at high rates of return for long periods of time.

  3. Compound my knowledge so I can better find companies that can reinvest capital at high rates of return.

Let’s get into each level.

Compounding Money With an Indefinite Time Horizon

Everyone has heard the example before. Invest $1000 a month at a 6% interest rate compounded annually for 40 years and you’ll retire a millionaire. In this specific example, you’d actually have $1.87 million. All you need is patience and a steady income and boom, your rich.

This is how most people build wealth through the stock market. Invest in companies or ETFs and let compound interest do its thing. On rare occasions, geniuses like the group at Renaissance Technologies will find ways to circumvent this. Don’t expect to be like them. The easiest way to build wealth is like Warren Buffett at Berkshire Hathaway. He made 99.7% of his money after the age of 52, mainly by sitting on his long-term holdings. You probably won’t be a billionaire like he is, and you almost certainly won’t hit his return numbers, but the majority of your wealth will be built in the second half of your life. If you play the game the right way of course.

If 40 years at 6% gets you $1.87 million, what will longer periods get? All else being equal (I’m assuming by the time of retirement you have assets that throw off cash flow), $1000 invested a month for 80 years gets you $21 million. That is 11.2x as much as a 40 year period. This is what I mean by an indefinite time horizon, and why I think it is so important. I want to compound my money for as long as humanly possible, everything else comes after that.

Companies with High Rates of Return for Long Periods

*This section was partly inspired by Charlie Munger’s 1994 speech at USC, the best speech ever given

Home Depot. Costco. Netflix. Amazon. Wal-Mart. Apple. Nvidia. These are examples of some of the best-performing stocks of the last 40 years. What do they all have in common? They were able to reinvest large amounts of capital and produce high rates of return on that capital.

It doesn’t matter if you manufacture GPUs or sell plywood. The most common similarity between high performing stocks is the ability to reinvest cash at high rates of return. This doesn’t mean that a company without large reinvestment opportunities will do poorly. It’s just that if you have a 20% ROIC for multiple decades, your stock tends to do pretty damn well.

The hard part is identifying what companies these will be, and doing it before everyone realizes how special they are. Not many investors can do it. But if you can and keep at it for a long period of time (i.e. indefinite time horizon), the results will be spectacular. For example, for the same scenario above, but with a 12% rate of return instead of 6%, $1000 a month compounded for 80 years ends up being $874.4 million. That is 41.6x the returns of a 6% scenario. 12% for 80 years is very, very optimistic for even the best investor. But if you can sustain anything close to that, you and everyone you know will be set for life. And that’s what this game is all about.

Compounding Knowledge

The biggest barrier for investors to generate wealth (if they choose to not invest in broad market ETFs, of course) is finding the great companies that will lead them to the promised land. It is no doubt a tough thing to do. That is why, to give myself the best opportunity possible to find market outperformers, I plan on compounding knowledge by reading/taking-in quality information every day of my life. This doesn’t just mean burying my head in finance books. From Munger’s 1994 speech:

“After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.”

I know I’m not a great stock picker right now. But if I continuously learn about the market, accounting, and the world around me, I will keep getting better and better until I find that 12% (or 14, or 10, or 16%) annual rate of return. It’s all about improving and then moving up to the next level of the investing game (from this Graham Duncan post):

  1. Apprentice — learning the game

  2. Expert — mastering the game you were taught

  3. Professional — making the game you were taught fit your own strengths and weaknesses

  4. Master — changing the game you play as part of your own self-expression and operating at scale

  5. Steward — becoming part of the playing field itself and mentoring the next generation

I know for a fact I’m at level 1 (Apprentice) right now. Eventually, I will get to level 2 and expect to get to level 3 and 4 someday. By writing and outlining my framework, I hope to help others achieve the same.

Disclosure: The author is not a financial advisor, and may have an interest in the companies discussed.


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