The Power of Compounding

Einstein was always intrigued by the power of compounding. This post isn’t about Einstein, but a post about how simple outperforming a benchmark is. Consider this a case study in compounding, and we’re going to examine Berkshire Hathaway’s Book Value Growth relative to the Book Value Growth of the S&P500. You should never go by past performance as a basis for future returns, so given that this is the only company in the world that beat the S&P500 Book Value growth rate over this long of a period, I figured that it was a superb example to expand on compounding with.nnThe following table shows the outperformance of Berkshire Hathaway’s Book Value Growth to S&P 500 growth with Dividends included from 1965 to the end of 2007.nnBerkshire’s Corporate Performance vs. the S&P 500, Annual Percentage Changenn(1) - in Per-Share Book Value of Berkshirenn(2) - in S&P 500 with Dividends IncludednnYear …….. (1) (2) (1)-(2)n1965 ……………………………………………. 23.8 10.0 13.8n1966 ……………………………………………. 20.3 (11.7) 32.0n1967 ……………………………………………. 11.0 30.9 (19.9)n1968 ……………………………………………. 19.0 11.0 8.0n1969 ……………………………………………. 16.2 (8.4) 24.6n1970 ……………………………………………. 12.0 3.9 8.1n1971 ……………………………………………. 16.4 14.6 1.8n1972 ……………………………………………. 21.7 18.9 2.8n1973 ……………………………………………. 4.7 (14.8) 19.5n1974 ……………………………………………. 5.5 (26.4) 31.9n1975 ……………………………………………. 21.9 37.2 (15.3)n1976 ……………………………………………. 59.3 23.6 35.7n1977 ……………………………………………. 31.9 (7.4) 39.3n1978 ……………………………………………. 24.0 6.4 17.6n1979 ……………………………………………. 35.7 18.2 17.5n1980 ……………………………………………. 19.3 32.3 (13.0)n1981 ……………………………………………. 31.4 (5.0) 36.4n1982 ……………………………………………. 40.0 21.4 18.6n1983 ……………………………………………. 32.3 22.4 9.9n1984 ……………………………………………. 13.6 6.1 7.5n1985 ……………………………………………. 48.2 31.6 16.6n1986 ……………………………………………. 26.1 18.6 7.5n1987 ……………………………………………. 19.5 5.1 14.4n1988 ……………………………………………. 20.1 16.6 3.5n1989 ……………………………………………. 44.4 31.7 12.7n1990 ……………………………………………. 7.4 (3.1) 10.5n1991 ……………………………………………. 39.6 30.5 9.1n1992 ……………………………………………. 20.3 7.6 12.7n1993 ……………………………………………. 14.3 10.1 4.2n1994 ……………………………………………. 13.9 1.3 12.6n1995 ……………………………………………. 43.1 37.6 5.5n1996 ……………………………………………. 31.8 23.0 8.8n1997 ……………………………………………. 34.1 33.4 .7n1998 ……………………………………………. 48.3 28.6 19.7n1999 ……………………………………………. .5 21.0 (20.5)n2000 ……………………………………………. 6.5 (9.1) 15.6n2001 ……………………………………………. (6.2) (11.9) 5.7n2002 ……………………………………………. 10.0 (22.1) 32.1n2003 ……………………………………………. 21.0 28.7 (7.7)n2004 ……………………………………………. 10.5 10.9 (.4)n2005 ……………………………………………. 6.4 4.9 1.5n2006 ……………………………………………. 18.4 15.8 2.6n2007 ……………………………………………. 11.0 5.5 5.5nCompounded Annual Gain – 1965-2007 21.1% 10.3% 10.8nOverall Gain – 1964-2007 400,863% 6,840%nnLet’s think about what it means to beat the S&P500 on average 10.46% annually. There’s taxes, as are described in the link this table came from can be seen at http://www.berkshirehathaway.com/2007ar/2007ar.pdfnnCompounded Annual Gain – 1965-2007nn21.1% The final compounded growth rate comes to 21.1%, or growth period on period of 400,000+%nn10.3% Growth from the S&P rounded off is approximately only 6,800+%nn10.8 This last number is Berkshire’s compounded outperformance, which will differ from a simple average because I was using a geometric mean.nnOverall Gain – 1964-2007 400,863% 6,840%nnFolks, I know that Berkshire’s results are extraordinary, but there are people operating at collective2.com that have built systems that I believe have long run viability that will absolutely decimate the S&P500 over long periods of time. Yes, I myself run such a system which can be visited at www.collective2.com/go/pairsqidqld . The fall to this site is that people believe that in coming there rather than to a professional that they will achieve instant success or wealth. The fact is, that when you understand that all investments are based relative to benchmarks, then you start to understand that it is a long run race that we’re in.nnWhile buy and hold most likely is a succesful strategy, on a risk adjusted basis we must conclude that it is not relative to even placing money into SPY or even QQQQ or the DIA.nnI’ve found over the six years of creating strategies that my biggest obstacle may have actually been myself. This year the pairs system I run was only up 1.5% approximately. What hit me at the end of the year was by how much the S&P 500 had fallen. The outperformance I calculated at the end of the year was 3,980 basis points. I’m saying that based on this, I had an outstanding breakthrough year, as I had beaten the S&P500 from March of 2007 by substantial amounts as well. All of these figures can be seen at the link above, but what I’m trying to get across is not actually that you should subscribe to me, because there is substantial risk involved in managing a portfolio that cannot be seen by the statistics, but that the number 1 factor that is not accounted for in my results on that site is the psychology. Your biggest enemy when you construct a long term financial plan has more to do with your psychology than about the system or plan you may have developed.nnYes, I’m an experienced trading system developer, but I don’t believe I’m that unique in the sense that most investors are of the same mind. We expect to sell at the highs, and buy in at the lows. We hold our financial advisors accountable for doing this, when it’s not actually the job of the advisor to buy and sell perfectly. Mainly what your understanding should be with an advisor is that they will attempt to outperform your benchmarks. If you’re aggressive, most likely your benchmark will be based on the S&P500 and other 100% equity benchmarks. It is a rare advisor that can beat the S&P by even 1% annually over ten years. For the past couple years, I can safely tell most of my clients that I have beaten the S&P 500 substantially. Once you have this sort of understanding with your financial advisor, you become a lot less concerned about day to day fluctuations, because the simple fact is that no matter where you could have put your money this year, you would have lost, save for holding cash and bonds that will not outperform inflation over the next 5 years.nnWhere then do I suggest you put your money?nnI strongly suggest you put your money with independent investment advisor representatives like myself that have taken the time to construct long term portfolios based on your specific needs and circumstances, with assurances that it will be re-allocated as needed on a regular basis. Most advisors, that is, namely brokers, are loyal to the firm and not actually to their clients. I’m sure some would dispute that, but it’s the very difference between a “BROKER” and an “INVESTMENT ADVISOR.”nnWithout giving too much away, every client I have is different, and are always in different situations than anybody else. Most plans from advisors are cookie cutter and come in a box. Having passed Level I of the CFA Curriculum, I’ve become a master of asset allocation, which is the very thing that Buffet describes himself as. He has said he calls himself “A Professional Asset Allocator.” That’s what I want you to think of myself and any other advisor you might work with as. You’ll know when they present to you if they’re talking about asset allocation the way it’s meant to be thought of, which includes being relative to a benchmark as well as evolving as you pass through each life cycle. I’ve picked up more clients than I thought possible by the simple fact that many advisors do not meet with their clients regularly to find out if circumstances have changed. I’ve changed portfolios over 10 times with each of my clients in the past 2 years. Mostly these were asset manager changes, but the pie was split up in the areas that were doing well and backed off from underperforming managers.nnI place trust with my managers, but it isn’t really an advisor’s job to buy and sell at the right time. Generally, we will have opinions that coincide with others that it may be time to buy or sell, but beating the benchmark is our primary focus. I’m saying that a good advisor is absolutely like Buffet. Buffet chooses stocks for the management and their ability to earn profits with their capital. The reason I chose to be an advisor in the first place was that I have this ability as well, and it all comes down to picking the managers for my clients that will outperform their benchmark relative to my clients and the benchmark’s expectations. I choose managers based on whether they hold stocks that I would be comfortable holding if the market shut down and then re-opened in 10 years. One of my asset managers does hold Berkshire Hathaway stock, but it wasn’t the fact that he held this company more than it was about the fact that the portfolio held stocks in it that have done superbly well over the last 30 years, and were in synch with my own personal preference for purchasing domestic value stocks. As a side note I also have a manager in International Stocks that was very bullish on Brazil for the past 8 years, and you can just see a chart of the Bovespa to see how well he did.nnOnce you accept that your investments are correlated with macroeconomic factors like domestic and global GDP, CPI, and Fed Interest Rates then you come to a realization that money will nearly always be made or lost relative to the market. As long as you can conserve capital and keep pace with the benchmark, I know you’ll outperform nearly everybody over time. I’m not suggesting a strictly ETF allocation, but that proper thought is given prior to investing and entrusting an advisor with your nest egg.nnI am confident that even though my business started during a recession, that because most clients have lost a lot less than the S&P with some even making money (thanks, Bonds) that my clients are doing fantastic when you understand the power of compounding relative to the S&P500.