Investing

The Power of Compounding

Drawdowns

We’ve discussed the importance, as well as the benefits, of diversification in several recent posts. One of the objectives of diversification is to minimize declines in your portfolio’s value (drawdowns) while still offering the potential for attractive returns. Why do we want to minimize drawdowns? The obvious answer is everybody wants to lose as little money as possible. Another, and perhaps less obvious, answer is you want to be able to sleep at night and you don’t want to put yourself into a position where you will sell everything because the pain is too severe. You may think to yourself that you could ride out a large drawdown or two but real world evidence suggests otherwise. The power our emotions play in getting us to make decisions that aren’t in our best interest is quite overwhelming. We’ve all been exposed to this power in one situation or another in our respective lives. Could you really ride out the two most recent recession era drawdowns in 2000-2002 and 2007-2009? The S&P 500 had a peak-to-trough decline of nearly 45% during the tech bust and a decline of over 50% during the most recent recession. During these periods of time you’re not only dealing with the actual decline in the dollar value of your portfolio but you’re also dealing with the doom and gloom of the media and the fear-mongering everyone else around you. It’s REALLY hard to stay invested during periods of great fear.

So to sum it up, we diversify to minimize portfolio drawdowns which provides us with a greater ability, than we might otherwise have, to stay invested to ride out the inevitable market declines.

Stay the Course

So why is it so important to stay invested? Going back to the historical drawdowns identified above, most of us will panic and sell at or near the point of maximum fear. The point of maximum fear tends to be near or at the bottom of a drawdown. We usually don’t buy back in until the majority of the decline has reversed. In essence, we’re buying high and selling low. Investment portfolios evaporate very quickly after a few episodes of buying high and selling low.

Compounding

By staying invested, you live to fight another day even if at the point of maximum fear you feel that everything you own is going to zero. Additionally, you get to compound returns. The principle of compounding isn’t new and is most often mentioned in the context of interest on savings. It works the same with investment portfolios. However, instead of compounding interest you get to compound investment returns which tend to be much higher than interest on savings over long periods of time, on average. By investing in a properly diversified portfolio, based on your time horizon and risk tolerance, and staying invested you can grow your initial investment quite dramatically. A portfolio invested (that stayed invested) in 60% S&P 500 and 40% US 10-year Treasuries generated a 6,300% return over a 45 year period beginning in 1972. While past performance is no guarantee of future performance, this particular example demonstrates the power of compounding.

So to bring our diversification conversation full circle, diversification is a tool that can assist you in staying invested over the long run (a good advisor is important too!). It’s imperative to your long-term success to stay invested even when it feels like the end of the world has arrived. Diversifying across asset classes, geographies and investment strategies helps to minimize drawdowns, which hopefully helps you to stay invested. You may miss out on upside over short periods of time (relative to a long time horizon) but the important point is to stay invested so your returns can compound and dramatically increase your wealth.