Quarterly Newsletter April 1, 2016
How Persistent Investing Can Generate Lollapalooza Results
“Wealth is largely the result of habit.”
– John Jacob Astor (1763-1848)
Bank accounts and interest-bearing securities (bonds) have not been very profitable lately. Is it too dangerous to keep most your savings in stocks? With stocks, the returns are highly variable from one year to the next, but over longer periods they smooth out. Everybody fears the risk and anguish of a plunge in the market. However, in the long run stocks have gone up two years out of every three.
Suppose a person invested $1,000 for a year, then the next year added $1,000 more, another $1,000 the third year, and kept on doing it. If the money grows at a 5% rate, after the first year (and second deposit) you’d have $2,050, after two years (third deposit) $3,152.50, after three years $4,310.12, etc. If you keep on doing this, it is kind of staggering how much you can end up with.* By repeating a beneficial but unspectacular action – investing $1,000 each year – one gets a lollapalooza result, far more money than was invested. This is the miracle of compounding, one of the wonders of the world.
Number Total Amount Rate of Return
of Years Invested 3.5% 5% 7% 10%
10 $10,000 $13,142 14,207 15,784 18,531
20 $20,000 30,269 35,719 44,865 64,002
30 $30,000 54,429 70,761 102,073 181,943
40 $40,000 88,509 127,840 214,610 487,852
Note that we are not assuming any heroic rates of return. Over the last 90 years or so stocks have averaged about 10%, but as we all know they can do a lot worse over shorter periods. (2000–2009, for example, was a ten-year spell when stocks averaged a loss of 1% per year.) There’s no guarantee the future will mirror the past. Naturally we prefer high returns, but even with gains well under 10%, it is apparent that compounding can do amazing things.
In the table above we used an annual savings amount of $1,000 for simplicity. That’s not a lot these days, and you might be able to do better. If someone is determined enough to save five or ten times that much, we can see how an average American family (typical
income $50,000 per year) could become millionaires by the time they are ready to retire. The American Dream is still there, offering one and all a chance to get ahead in life. We do not say it will be easy. It is seldom easy. But it is possible, and some people do it.
What could go wrong with this optimistic scenario? Well, lots of things can go wrong, for life has its ups and downs. At the start of our career, a tiny income may leave nothing for savings. Maybe at times we will suffer prolonged spells of illness, or unemployment, when we cannot put any money aside. At other times, we may be blessed with a good paying job and can afford to save more. But get into the habit of putting aside something out of every paycheck, even if there is some variation. Ten percent is good. Fifteen percent is better. You’ll see your wealth grow that much faster.
*For those who enjoy algebra: If the same amount of savings S is deposited each year, compounding at r percent, the total amount accumulated after n years is
S((1+r)n+1 – 1)
Zero Interest Rates: Thanks for Nothing
The recent years of extremely low interest rates, an experiment which the government engineered and says we need, have not been a very happy time for Americans. Retirees who once earned 8% in a money market fund have seen the income from their life’s savings shrivel to nothing. Low rates make it much harder for ordinary middle-class citizens to accumulate wealth the old fashioned way, by working hard and watching their savings grow. Meanwhile, large institutional investors like insurance companies and pension funds carry heavy future-year benefit obligations that are quite well defined statistically. For them, low bond returns mean a disturbing shortfall in funding those payouts, and the possibility of insolvency looming not far down the road.
Near-zero interest rates are a new experience for you, for us, and also for our central- planning wizards at the Federal Reserve in Washington. We find ourselves in a strange environment where basic financial common sense starts to break down. Individual savers see little reason to keep their funds in a bank, apart from the safekeeping factor. Unable to find a safe way to earn decent returns, they may stretch for yield via speculative mutual funds or risky non-investment-grade (“junk”) bonds that could eventually lose them serious money. Institutional investors, likewise frustrated in their search for yield, are tempted by the same pressures on a much larger scale. These are not healthy incentives.
At the same time that extremely low interest rates punish savers, they encourage reckless borrowing by hiding the (potentially) crushing burden of debt. That largest and most privileged of borrowers, the U.S. government, now acts as if money in unlimited amounts can be borrowed without cost, taking on far more debt than they – i.e., we – can ever hope to repay. To demand on short notice that our 315 million people pay off a federal debt of $20 trillion ($20,000,000,000,000) would be to invite revolution. Indeed, we would be hard pressed even to pay the annual interest, if rates were to return to a more normal 5% – 6% range. You can be sure that if the government ever gets into a real financial bind, their problem will very quickly become our problem. Sadly, irresponsible borrowing is nothing new in America; it goes back many decades and with the active participation of both political parties.
Warren Buffett has noted that taking on too much debt is about the only way a rich, smart, industrious person can end up going broke. Are the rules different for nations?
The Enduring Strength of the American Economy
In our 240 years of existence as a country, the United States has suffered many calamities – quite a few of them just in the last ten or twenty years.
- Terrorist attack
- High taxes, low taxes
- High oil prices, low oil prices
- High, low, zero, negative interest rates
- Assassination of a President
- Economic recessions
- Epidemics, bean beetles, tent caterpillars, Democrats, Republicans
- Financial panic
- Bank failures, corporate bankruptcies
- Stock market crashes
- Strikes by labor unions
- Floods, earthquakes, storms, drought
Most of these came as a surprise, seemingly out of nowhere, causing much distraction and waste of resources. Each time, American businesses absorbed the shock, then looked around at their situation and made changes that seemed necessary. In time, healthy enterprises recovered from their setbacks and generally remained healthy.
Though a crisis may have seemed dire at the time, though people shook their heads gravely and said “Nothing will be the same after this,” the American economy has over the years proved remarkably resilient, adaptable, and steady. That makes it a great place to invest, and based on past experience, we believe it will continue to be so. With a diversified portfolio of strong, profitable companies, your income arrives from many independent sources. It is most unlikely that more than a couple of the apple carts would be overturned at any one time. That kind of stability brings a peace of mind that lets conservative investors sleep well.
Written by George Donner