Compounding

Superior investing is achieving high rates of return for long periods of time while taking the least amount of risk.

Consider the compound interest formula:

A = P (1 + r) ^ t

Time is a power factor. Principal is a multiplicative factor. The rate of return is an additive factor. So the order of importance is:

1. Time

2. Capital

3. Returns

Having a long duration investing practice is paramount, since compounding will not work in one’s favour unless done for a long period of time. Next, protection of capital is necessary implying the importance of taking low risk, and finally the rate of return is the least important of the three.

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How compounding applies in businesses.

Time:

Being able to remain in business for a long period of time, by making sure that there is a durable demand for their product, no major mistakes will kill the business, and striving to build and expand a competitive advantage.

Capital:

Being able to find avenues to keep deploying large amounts of capital.

Rate of return:

Protecting capital, earning high returns on current investments, and making sure that the future investments also earn high returns.

Higher returns will provide more profits for the business, provided that they are not value destructive, i.e., they earn higher than the average cost of capital. It is more important that the business finds ways of investing more funds into good opportunities, than to invest lower amount in avenues which can give you great returns. After this, it is important to keep repeating the activities of such a profitable venture for a long time to come.

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How compounding applies in investing:

Time:

Starting early gives you a longer time to earn returns and reinvest profits. Looked at it another way, if an investment needs a certain amount of time to grow, being aware of the holding period that is the most relevant to the investment becomes the top priority.

Capital:

Allocating more capital to great opportunities, avoiding unnecessary expenses, and committing time, focus, and capital to the important places and avoiding sub-optimal work.

Rate of return:

Avoiding investments that have a low probability of high returns, being very strict in deciding where to deploy capital, and not selling equity in great businesses.

While the returns are an extremely important part of an investment manager's job, the investor can gain much more by saving more money from their earnings and investing higher amounts into the businesses. A lower return on a higher capital will create more wealth for the investor. Be consistent with this process for a long time and stick to the basics.