For investors looking to put money to work for them, there’s few places better to make a return than the stock market. When combined with compound interest, an average return can build significant wealth, while outperformance can mean even great amounts– even for investors who start with small amounts.
This blog post will look at the impact that outperformance in the stock market can make, even something as small as 1% more per year.
While this might not be obvious to beginners who are just starting in their investing journey, the truth is that an extra 1% return can add up to hundreds of thousands of dollars in the long term.
When you take into account that investing should be a lifetime habit, it’s very reasonable for investors to examine their performance over a matter of decades rather than over a single 1 year period. A 1% outperformance probably won’t move the needle much over 1 year, but it can have significant implications over 20, or 30, or 40+ years.
To understand how different returns can build great wealth, it’s important to understand compound interest. Famously known as the “8th wonder of the world”, compound interest creates an exponential effect to the capital you invest, multiplying over time and accelerating its progress the longer you do it.
The way that compound interest is created in the stock market is through two separate forces: the ability of companies to reinvest their earnings into the business to spurn additional growth, and the ability of shareholders to reinvest their dividends into stocks they already own to grow their own holdings.
When you combine these two forces of compound interest together, you essentially double the compounding rate– almost in the same way you’d take a pile of dollars and square it (multiply it on itself).
Examples of Compound Interest
For example, say a business is able to earn $225 a year on $1,500 of assets. If the business takes its $225 of profits in year 1 and buys more assets with it, the business will have $1,725 of assets in year two. Now instead of earning $225 on $1,500 it can potentially earn $258 on $1,725. This grows the earnings stream, which can then allow the business to buy more and more assets and grow profits exponentially.
Expanding this example out, by year 3 the business could have $1,983 in assets and be earning $297 on those assets. As you can see, the amount of earnings growth increases– because more earnings creates more earnings and it increases faster and faster as time goes on. It’s akin to a snowball rolling down a hill– which piles on more and more snow the longer it rolls.
The same is true for investors who buy and hold for the long term and reinvest their dividends. Say an investor gets a $30 dividend payment on a $1,000 stock. If they reinvest the dividend from year 1, they will have 1.03 shares instead of just 1 share in year 2. Now instead of getting just a $30 dividend on 1 share in year 2, they will receive a $30.90 dividend on 1.03 shares.
Like with the business, the growth of the income stream (in the form of a dividend) increases exponentially as well. The income stream can grow faster and faster as time goes by.
One last feature of compound interest, the stock market, and dividend investors is what is possible when a company chooses to grow their dividend payments every year (as many often do). Now you have the growth of the business, the growth of your personal holdings through dividend reinvestment, AND the growth of the dividend payment– all working together to grow your wealth exponentially.
This is how true wealth in the stock market can be attained. Not through picking a stock that doubles or triples in one year (which is hard to do consistently), but by letting your investments utilize the powers of compounding. Every year the growth should accelerate.
When you add the ability to outperform the market into the mix, all of the same compounding forces work in the same way but do so even faster. This allows for growth that multiplies on itself at a larger scale, like if you were to roll a snowball at a running start instead of a slow walking start.
And the real world outcome of outperformance can make a major difference over an investor’s lifetime, especially the more alpha (outperformance by percentage points) is obtained.
To show the scope of this potential, it’s first helpful to understand what the stock market generally averages on a return basis for investors. Having this point of context, we can then estimate various levels of outperformance to show how much of a difference they can make. Essentially, we want to know at what scale will accelerated compound interest lead to greater amounts of wealth.
The Historical Return of Various Asset Classes
The long term average stock market return has been 10% a year. When some experts quote a 7% a year number for the long term performance of the stock market, they are including inflation into the calculation. But often they don’t account for things that can counter balance inflation– like raises at a person’s job.
And although inflation does play a role in overall returns, it doesn’t affect the compound interest on your initial investment. In fact, it actually clouds the calculation because returns accelerate at higher percentages– so the difference between say 10% and 13% is much more significant than the difference between 7% and 10%. Inflation won’t have a compounding effect to your money per se, while your investments definitely will experience a compounding effect that will lead to higher overall return.
For our purposes I’ll use the 10% number without accounting for the average 3% a year rate of inflation. We can always make our calculations (outperformance and on just average returns) so that they take into account the real compounding effect, and then back out inflation at the end for a “real” instead of “nominal” return.
A return of that size, 10%, is very significant. You definitely won’t find that at a bank these days…
It’d be tough to get it in a bond. You may outperform that number with certain real estate, but you won’t have nearly the flexibility on liquidity. In fact, 10% a year is so significant, especially when you take a simple example such as the following.
The Compounding Effect of Average Stock Market Returns
Take $150 a month. This is close to what the average person would pay these days for a couple of cell phone lines. The average person usually has a cell phone, so they should be able to afford $150 a month.
Now, using the following compound interest calculator, you can see that someone investing $150/ mo and getting 10% a year returns over a 40 year period would have $796,666.
Increase that return by just 1% a year. You’d think– ok, an extra 1% on $150 is about $1.50– so over this time period it should increase the return by about $79,000, which doesn’t seem like much in the grand scheme of things. Right? Well actually…
The same $150/ mo now getting 11% a year (an outperformance of just 1%) over a 40 year time period would be $1,047,286. That’s an over $200k difference. It’s that extra $200k+ that drives me to seek better than average stock market returns. That’s why I personally pick individual stocks over ETFs, and why I encourage beginning investors to do the same, if they can find themselves with a knack to understand it.
Don’t Make Excuses, Make a Plan
You might be thinking…
“I don’t have 40 years to invest”, “I’m getting such a late start”, “I’m so behind on my retirement savings”.
If you think about investing as similar to planting a tree, which is has a lot of similarities to, you can take the following Chinese proverb as a place of comfort: “The best time to plant a tree was 20 years ago. The second best time is now”
It’s important to remember that investing isn’t something that stops once you hit retirement, whatever age that means for you– 65 or otherwise. You can continue benefiting off the effects of compound interest as long as you’re saving and investing something. There’s a lot of ways to lower expenses as you age, especially if you have a paid off mortgage, less kids to feed, a slower and less stressful lifestyle…
Investing is a lifetime endeavor and it doesn’t have to stop just because you turn 65. You can continue growing wealth through compound interest until the day you die. And if you can find stocks that drive outperformance, it can improve your results in an even bigger way.
Secondly, the amount of medical innovation that we’ve seen in the last hundreds of years has been astounding. Life expectancy ranges are much higher than they’ve been historically, and many people’s quality of life are at much greater levels than previous generations who’ve aged. There’s also many more office jobs that are available for people to work at than before. The average person could conceivably be working much longer than the traditional age 65 cut-off. That would mean even more time for your money to compound.
I could give you countless more examples of significant wealth being built by using higher outperformance numbers (2% or 3% per year instead of 1%), or higher initial and recurring amounts ($500 or $750 per month)– and you’d see results that are in the multi-millions instead of millions.
I highly encourage you, if you are at all interested in investing in the stock market and doing it for the rest of your life, to take a look at the basic compound interest calculator and input your own personal numbers in there. Play with the “length of time” and “interest rates” values.
It can really open your eyes to the possibilities that are driven by investments compounding over a long period of time.
A Proven Strategy for Achieving Outperformance
The next step to this discovery is finding ways to achieve outperformance. And to do that, it only makes sense to look throughout history at the investors who’ve been successful at beating the market, and see if they share strategies or lessons from their own personal experiences.
Turns out that many billionaires have achieved this exact feat, and have not been shy to credit value investing as the way that they have done it. Value investing was a strategy first taken to the public eye by Benjamin Graham, Warren Buffett’s teacher and mentor at Columbia University.
Buffett has taken the teachings of Graham and used them to turn Berkshire from $22 a share to $301,000 a share, and counting. Buffett is not shy about sharing the principles of value investing in his many public writings– notably his annual shareholder letters.
He also recommends The Intelligent Investor, the best selling book by Benjamin Graham that introduces the basic concepts of value investing so that any beginner can get started in learning the process and picking stocks in that way.
To say that Graham, Buffett and others have been able to achieve outperformance in the stock market would be a massive understatement. Graham outperformed the market by over 7% over a period of 30 years (17% annualized by the end of his time at Graham-Newman), and Buffett has outperformed and continued to outperform the market, mostly averaging around 20% annualized and an average of 29.5% when he ran his hedge fund from 1957- 1969.
If you can understand the basic idea that the market is fearful and greedy and that you can buy low and sell high stocks to try and achieve alpha, then you likely have the ability to understand value investing pretty easily.
Once you can understand the fundamentals, achieve the skills to use the fundamentals to pick the right stocks, and then behave in a rational way that will keep your returns compounding over the long term, then you can use a strategy like value investing to pursue outperformance in the stock market. Like you can see in the examples above, it can be one of the most valuable things you ever learn how to do.
I wrote a blog post that’s really a guide to introduce readers into value investing, and walk through the various topics in an easy-to-follow way. It was designed for beginners and includes the exact resources I use when picking stocks, and a list of some of the best books written about value investing by some of the most successful investors of all time. Check it out, and best of luck with your investing. I hope you too can see the potential that even a few percentage points can make over time.