It’s rare for me to bump into other active investors in my daily life. I tend not to mention my passion for investing. But if it does slip out, the most common reaction from others is concern about my gambling habit!
And to many people, investing in stocks and shares does seem like gambling. But that’s probably because most folks don’t research the businesses behind stocks. And they have little interest in investment strategies, economics, or other considerations that could help them pick winning stocks to hold.
The power of compounding gains
Many people save into passive investments, managed funds and other vehicles such as pension schemes. Then they get on with their lives. And there’s nothing wrong with that. The great investor Warren Buffett recently pointed out America’s S&P 500 index has delivered annualised total returns of just over 10% a year since 1965.
If I’d simply invested in a tracker fund following that index and left my money alone for years, I’d have done all right. For example, compounding 10% annualised gains for 10 years would turn a £10,000 investment into almost £26,000.
However, it’s correct to assume investing in stocks involves risks. All shares have the potential to fall as well as to rise. But long-term outcomes tend to be driven by factors such as the progress of the underlying business and investor speculation. And stocks don’t all behave in the same way. The trick is to pick the ‘right’ stocks in the first place.
And the success of well-known investors such as Buffett proves that investing can be executed successfully. However, even he can’t predict the short-term movement of stock prices. Instead, he concentrates on identifying good quality businesses and he buys their stocks when the valuations look attractive. Then he aims to hold those stocks for long periods.
And his returns then often arise as those businesses power ahead, building value by increasing their earnings and assets. Often such progress reflects in higher dividends and higher share prices over time.
Aiming for better compounded returns
For him, the strategy has worked well. And since 1965, he’s achieved an annualised investment return of 20% within his company Berkshire Hathaway. But is it worth all the effort to aim for returns that beat an index? After all, even Buffett has ‘only’ managed to double the annualised return of the S&P 500.
I think it is worth it because compounding 20% annualised gains for 10 years would turn a £10,000 investment into almost £62,000. And that gain is more than three times the size of the one I’d receive from compounding 10% annualised gains. Indeed, the power of compounding is enormous. And little changes in the rate of return make big differences to the end result over time.
So I’m aiming to compound my investing pot at the highest rate I can with the aim of using the funds to retire early. And to do that, I’m focusing on Buffett’s method of picking quality businesses, buying stocks when valuations look fair, and holding for a long time.
Of course, even following Buffett’s methods doesn’t guarantee a positive investment outcome. And some of his investments haven’t worked out well for him either. But the risks that come with shares aren’t going to stop me from trying because they are often balanced out by the potential rewards and opportunities as well.