The Joy of Compounding

  • Matt Hagemann
    Matt Hagemann

    Portfolio Manager

On August 3, 1492 Christopher Columbus and his crew set sail from the port of Palos in southern Spain. For 35 days, the crew of 86 Spanish sailors sailed westward searching for a passage to China and India where they hoped to find gold. The journey was long.

Columbus’s voyage cost approximately 2 million Spanish maravedis. One maravedi would be about 50 cents today, which means that the voyage cost a million current U.S. dollars. He had to petition King Ferdinand II and Queen Isabella of Spain for six years for the funds needed to make his voyage. The journey was costly.

Many of the crew died from scurvy, a disease caused by a severe vitamin C deficiency due to poor nutrition. The journey was unsafe.

327 years later, the first steamship crossed the Atlantic in 1819. It took almost 9 days, one fourth of the time it took Columbus. Today’s record of crossing the Atlantic by sea was set by American ocean liner United States in July 1952: 3 days, 10 hours, 40 minutes. One tenth of the time it took Columbus.

The occasions are a reminder of just how dramatically transoceanic travel has improved in terms of speed, affordability and safety of travel times. The evolution of which is the stepwise climbing of a ladder from simple to complex.

Travel times have shortened as a direct result of technological progress compounding exponentially. Over the centuries, explorers, innovators and entrepreneurs were determined to remove risky components from the journey by building on top of one another’s work. One of the most widely accepted concepts has been ‘creative destruction’ which derived by Joseph Schumpeter. It postulates an incessant struggle among industries in which outdated, old technologies are replaced by selections from the new, the threat of which stimulates industrial innovation.

This brings me to systems thinking: compounding has a lot to do with it. Individual components of a system interact with each other in a feedback loop. An action triggers an effect. You observe whether the effect is desired or needs to be improved on before invoking the action again. This is a systematic process where doing more of the same will propel exponential growth on the same trajectory. A system requires a feedback loop before any favorable outcome can materialize. Without one, you’re purely poking in the dark and there’s nothing you can build upon.

As with crossing the Atlantic, which was made faster, cheaper and safer over the centuries, the individual investor can establish feedback loops that will compound wealth faster, cheaper and safer.

Take Warren Buffett for example. He consistently maintained the same method of operation: Buy securities priced below intrinsic value with a large enough margin of safety, and sell them once they reached or surpassed their intrinsic value. He built upon a strategy of his professor and mentor Benjamin Graham and gave it his own twist.

He repeatedly described this method of operation throughout the early letters to his investment partners.

A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety with each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.

It’s commonly claimed that Buffett reads 500 pages a day to compound knowledge at a rapid rate. It has helped him refine his systems thinking over decades.

Devising a system is as easy as it sounds — but it’s also as hard as it sounds. The established way is to build upon someone’s proven system and to personalize it. You have to iterate through what works for yourself and what not. Just like how Buffett took Graham’s strategy and made it his own.

An initial spark of interest triggers action, and action nourishes interest. It becomes a feedback loop in itself which morphs interest into a masterpiece. As we learn, our brain releases dopamine and we feel pleasure. The learned is incorporated into a greater whole. The greater whole can be picked up by others after us. What results of it is often associated with excellence that comes naturally to you. This, in my humble opinion, is the joy of compounding.

Coming back to Christopher Columbus.

King Ferdinand II and Queen Isabella had agreed to Columbus’ opulent demands if he succeeded on his first voyage: he would be knighted, appointed Admiral of the Ocean Sea, made the viceroy of any new lands, and awarded ten percent of any new wealth.

Columbus had arguably become one of the most famous men in history. His quest for gold remained fruitless and he was stripped of his noble titles on the subsequent voyages. He may have had become one of the richest men on top, but nonetheless, his boldness kicked off centuries of exploration, innovation and entrepreneurship that we’re all still benefiting from.

Published Friday, May 15, 2020

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