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Home Investing Strategy Compounding: How it Works and Why Diversification is Key

Compounding: How it Works and Why Diversification is Key

Compounding is amazing, isn’t it? Just look at the graph below. It shows the nominal growth of the S&P 500, a prominent US stock market barometer, in the last 150 years.

Source: Line chart using Robert Shiller’s S&P 500 data

What’s interesting about the chart is that the S&P 500’s growth accelerated over time. That’s exactly how compounding works. Nominal growth starts off slow but increases over time.

The chart below of the S&P500 over the last 150 years shows the same thing as above, but in logarithmic form. It gives a clearer picture of the percentage returns of the stock market over the same time frame.

Source: Line chart using Robert Shiller’s S&P 500 data

The log-chart of the S&P 500 over the past 150 years is a fairly straight line up. What this tells us is that even though the return of US stocks have accelerated nominally, there was a fairly consistent growth in percentage terms over the time studied.

How do stocks compound?

This leads us to the next question. How?

In order to produce a 10% annual return for shareholders, a company that has a market value of $1 million needs to create $100,000 in shareholder value this year. The next year, in order to compound at the same rate, the company now needs to create $110,000 in shareholder value.

That figure grows exponentially and by year 30, the company now needs to create $1,586,309.30 to keep generating a 10% increase in shareholder value.

On paper, that seems outrageous and highly improbable. However, based on the historical returns of the stock market, we see that the S&P 500 has indeed managed to achieve this feat.

The reason is that companies can reinvest the capital they’ve earned. A larger invested capital base can result in larger profits. As long as they can keep reinvesting their earned capital at a similar rate of return, they can keep compounding shareholder value.

But here’s the catch…

Although I’ve given an example of how a company can compound shareholder value over time, it really is not that simple.

Not all companies can create more shareholder value every year. In reality, corporations may find it hard to deploy their new capital at similar rates of return. Businesses that operate in highly competitive industries or are being disrupted may even face declining profits and are destroying shareholder value each year if they reinvest their capital into the business.

In fact, most of the returns from stock market indexes are due to just a handful of big winners. In 2014, JP Morgan released an interesting report on the distribution of stock returns. The report looked at the “lifetime” price returns of stocks versus the Russell 3000, an index of the biggest 3000 stocks in the US over a 35-year period.

What JP Morgan found was that from 1980 to 2014, the median stock underperformed the Russell 3000 by 54%. Two-thirds of all stocks underperformed the Russell 3000. The chart below shows the lifetime returns on individual stocks vs Russell 3000 from 1980 to 2014.

Source: JP Morgan report

Moreover, on an absolute return basis and during the same time period, 40% of all stocks had a negative absolute return.

Even stocks within the S&P 500, a proxy for 500 of the largest and most successful US-listed companies, exhibited the same. There were over 320 S&P 500 deletions from 1980 to 2014 that were a consequence of stocks that failed, were removed due to substantial declines in market value, or were acquired after suffering a decline. The impressive growth you saw in the S&P 500 earlier was, hence, due to just a relatively small number of what JP Morgan terms “extreme winners”.

That’s why diversification is key

Based on JP Morgan’s 2014 report, if you picked just one random stock to invest in, you had a 66% chance to underperform the market and a 40% chance to have a negative return.

This is why diversification is key.

If historical returns are anything to go by, diversification is not just safer but also gives you a higher chance to gain exposure to “extreme winners.” Just a tiny exposure to these outperformers can make up for the relative underperformance in many other stocks.

Last words

Compounding is a game-changer when it works.

But the reality is that not all stocks compound in value over a long period of time. Many may actually destroy shareholder value over their lifetime. A useful quote from Warren Buffet comes to mind: “Time is the friend of the wonderful business, the enemy of the mediocre.”

Given the wide divergence of returns between winners and losers, we can’t take compounding for granted. By diversifying across a basket of stocks with a sound investment framework, or by buying a fund that tracks a broadly-diversified market index, we reduce our downside risk and increase our odds of earning positive returns.

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Note: An earlier version of this article was published at The Good Investorsa personal blog run by our friends.

Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.