Blog | CB Investment Management

Want To Make Higher Returns with Less Risk? Harness The Power Of Compounding.

Want To Make Higher Returns with Less Risk?      Harness The Power Of Compounding.

It is impossible for a person to begin to learn what he thinks he already knows.”

Epictetus

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Einstein

“How we built a wealth compounding machine.”

Warren Buffett

Compounding is core to investing and yet widely and deeply misunderstood

“Best Investors” wholly embrace it.  However, most investors miss it completely, right at the outset, and then never properly review it. Returns alone tell you very little about your long term trajectory. It’s compounding that informs you whether or not you will be successful over time.  

What you measure defines the kind of investor you are. If all you measure is return then all you have is a series of return outcomes, not necessarily connected to each other with a coherent theme over time. How do your good return periods relate to your bad return periods? How do they net out in your long-term favor? That’s compounding. That’s what matters, whether or not you are measuring it.

Most investors do one version of two different types of investing:

  1. Short term return maximizing (where short term is anything less than 5 years)
  2. Compounding. Which maximizes long term return through optimizing five prioritized metrics.

Which one are you? You can’t be both. Only one or the other can be your priority. The great majority of investors focus on short term return. All the “Best Investors” focus on compounding.

What you choose defines your Objectives and Assessments. It will define every investment decision you will make, and the long-term success of your investing. 

Doesn’t my investment advisor do compounding? Probably not as we’ll show.

The biggest hedge fund failure in history had all the best Wall Street and Nobel Prize  winning credentials. It had completely ignored compounding metrics. Yet because of high short term returns the demand for the fund seemed unlimited. Most investors didn’t care about compounding either.

The great news is that you don’t even have to take anything on trust. Compounding assessments are mathematical and available in real time. So it is readily clear whether a manager has the real wisdom and character to understand the deep principles of investing and has the grit and smarts to execute consistently. That puts the investor in full control. The data is all you need. No opinion required.

This becomes visible through five metrics in the results. You can verify this just through math. If a manager does not have the data. They are not compounding.

Compounding Benefits are irrefutable, yet widely ignored

What does that look like? Take a look at two extreme versions.

In the chart below, on the left is the world’s biggest hedge fund for a time in the 1990s, Long Term Capital Management, LTCM. On the right is the 30 year record of the Medallion fund, which with tight compounding metrics  compounded at over 30% annual rate, with only one losing year and a small one at that.

LTCM embraced risk for high short term returns, but got too overconfident and then failed to assess and manage their liquidity and risk. When the market turned against them, they were unprepared and were wiped out.

In an obsessive chase for return, LTCM had completed failed in setting up a credible long term objective and assessment methodology. Nevertheless, they had almost unlimited demand for their fund. Investors saw the returns and got excited. Apparently, no other information was necessary.

Best Investor Seth Klarman was approached by LTCM to invest in their fund. He turned down the opportunity on risk grounds. I, myself, was interviewed by John Merriweather for partnership, but we clearly did not see eye to eye on risk management.

The medallion fund had a coherent and comprehensive real time objective and assessment process. That is what properly constructed compounding provides, so long as you thoroughly understand what metrics must be observed to compound efficiently.

Sole use of the return metric can be a disaster

Sole use of short-term return maximization as an objective and assessment is suboptimal and can be a disaster, even if it can seem to be working for several years. Over a period of decades any approach will have to be able to deal with adversity, and likely several times. That needs to be built into your strategy as it is with compounding.

Compounding entirely refutes any strategy that allocates to risk as a single factor. This directly refutes standard Adviser and SEC allocation advice.

It is standard procedure for portfolio construction to allow maximum risk levels according to the ability, or “Suitability”, of an investors capability. The assumption being that higher risk leads to higher returns. What if that assumption is completely wrong?

The chart below shows that even in a record 27 year bull market the lowest volatility S&P500 stocks outperformed the highest volatility S&P 500 stocks.

The lowest volatility stocks would also outperform in a sideways or down market.

The reason for this result is simply the influence of compounding. The key factor for compounding is drawdown, or losses, in your portfolio. The higher the volatility of your portfolio the greater the drawdowns will be. So high volatility portfolios compound very poorly.

Compounding  means that high volatility portfolios in a passive allocation are a misallocation.

Make sure you are not falling for this incorrect dogma that high risk equals high long term return. Here is the proof of this misallocation. It’s just math and observation. Once Compounding becomes understood it provides a significant edge to outperforming, even with lower risk! Using this insight it is possible to transform investment opportunities.

The Pure Quant software enables outperformance of Billionaire Portfolios with multiple lower risk methodologies as shown in my book.

 Compounding is so clear that it enables real time performance monitoring. Far greater accountability, transparency, and objective verification

Is your portfolio outperforming on a compounding basis? Get access to all the information for you to check in just a few seconds. If you are in the high return/low risk quadrant you are on track for great compounding. If you are not you know immediately and can make changes.

 

                                   Compounding has multiple impacts on the performance of your portfolio and finances more generally, whether or not you harness it. It is profound, but rarely discussed.

  1. If you do not understand how compounding impacts investing, and you are following standard methodologies, there is a strong chance you are sub-optimally allocating
  2. Furthermore, most likely you are taking much greater risk than is efficient.
  3. Most likely you are not using low risk strategies as aggressively as you could be for extra high returns. As in the Pure Quant strategy.
  4. The clarity of compounding discipline provides unparalleled transparency, accountability, and objective verification.
  5. Low volatility and stable financial conditions improve your security and ability to plan.

If you want higher returns with lower risk , more control, and a better idea of where your finances are going embrace compounding. The most successful investors of all time have shown proof of concept.

Listen to Warren Buffet and Charlie Munger.

Best Practice is a matter of your Best Interest.


Education and a Commitment to Informed Consent is an Obligation.

Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

Sign up to receive the best practice community insights directly into your inbox

Leave a Comment

Your email address will not be published. Required fields are marked *

Related Posts

Sign up to receive the best practice community insights directly into your inbox