This is according to me is a very interesting post where i would like comments from readers.
We always focus on Analysis whether it is Technical /Fundamental/Quant/Value and various things but there is a topic which nobody wants to delve deeper.
The topic is Capital and Compounding.
Investing/Trading is a highly capital intensive business. As your returns are a direct by product of how you invest/trade. The end product is if you started with X it becomes 2x/3x/5x over long periods of time.
But everyone only focuses on the final returns. There are lot of sellers who sell you the Returns Story/Compounding etc. ( Mind you am one of them as we are into advisory services ).
But everyone forgets about the returns are always going to be a function of your Capital ( i.e X ) and how you rightly implement analysis for compounding of capital.
This is the advertisement by NSE itself.
In this example how NSE has tried selling ETFs by showing a Car and a Scooter to entice investors. . I have covered this in an older article as to how Nifty returns was 9% since inception but NSE has conveniently taken a well fitting period.
( I cant get hold of another picture i saw on facebook, about how one could have bought a mercedes in 10 years by buying Maruti shares instead of a Maruti 800 forgetting that for 10 years the kids went to school safely in Maruti 800)
But even if we believe NSE, it forgets the biggest factor of compounding which every newbie value investor also misses out is
If you want compounding you cannot remove/lose capital but only add !!
Lets take an example somebody makes a lot of money in a purple patch at 40% CAGR and say another one who made 25%
Starting Capital – 5 lakhs , CAGR of 40% and 25% for 5 yrs.
See how a bear market or a mistake of losing 50% capital can knock your CAGR. ( What if you need money for an emergency in such times )
|Dudes||Capital||Ending Capital on 5th year||50% loss||6 yr CAGR|
Now again if you keep compounding at the pace of a Bull Market Machine
|Dudes||Capital||Ending Capital on 20th year||50% loss||20 yr CAGR|
So even another 14 years of a similar good purple patch will not take you to same levels of compounding.
Now the smart guys will say how can you lose 50% if you are a smart Value Investor !
In this video just see how Warren Buffet and Mohnish Pabrai who lost 25-55% from peak values are being made fun off. They are way bigger today !!
This is what frustration can do in a Bear Market. If Warren Buffet and Mohnish Pabrai could get a 25-55% notional hit as a buy and hold investor even we should accept it can happen to all in a bad year.
-> Conserve your Capital.
But now consider you are better than Buffet and do not get a 25-50% drop in your investment career but you decide after 5 super years to spend 50% of your wealth on a World Trip than your investment CAGR will never be back to same levels.
All the value investors , mutual funds, financial planners will only talk about compounding and not about conserving.
The second part about good compounding is you need to live for a long long time without the need of money invested !!
If this was so easy in the current materialistic world there would be a lot of Warren Buffets
( look at your Gadgets+ Travel +Eating Out to Income Ratio. If it is greater than 2-3 you better start earning a lot more else you are doomed )
Even though people talk about compounding as the 8th wonder it also relies on the simple fact you need capital and you need to keep adding capital to hit it really big !!
For example Warren Buffet model is of operating businesses like insurance and other which keeps the capital flowing to equity investments. Most of the top investors have become big not just by compounding but adding capital to it continuously in their career. ( every big guy has a mutual fund, llp, hedge fund isnt it? )
This is never going to be possible for everyone. ( Can you raise funds ? , Will your investors be able to digest a 2000/2008/2011 ? ) .
I would love a lot of capital to invest for a fee !! ( Hope you get it its Fee and not Free)
This is what a lot of us are doing.
If we look at the above process of four buckets – There are some important inferences.
-> compounding your earnings ( job, business ) is the foremost important thing unless you have inheritance, dividends, rents coming from other assets which are huge.
-> Spending prudently will allow you to increase your capital in assets.
-> Increase exposure to equities as % of networth.
-> Learn all ways of increasing market returns whether it is value investing/technical analysis etc but always remember it all helps only if you have some capital !!
Would like comments from readers on the above random post on Compounding.
This also answers a question – There are so many Value Investor biggies like Warren Buffet and no Technical Analyst ?
Its a survivorship bias 🙂 and secondly a lot of Technical Analyst will have these two simple problems.
- > Low Start Up Capital
- > Needs to Pull Out from Capital / Profits to remove Expenses so adding capital is going to remain difficult.
But this is not just applicable to me but also you !!
The one prime reason for me to continue Advisory Services is to fill the Red Bucket ( If i had a big inheritance of capital or lottery capital or if i can raise a lot of free capital i might re-think)
Above all this is a very tough industry 🙂 and you will be paid only till you are consistent and more right than wrong.
This was PART 1 of the article where we focused on simple topics related to Compounding and Capital. In part 2 we will look at how people try to sell you this. Will make this a series of posts.
Please do put your comments and if anything else mail me on email@example.com
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