Critical Chance

Category: Compounding

  • The Power of Consistency

    The Power of Consistency

    Warren Buffet has an interesting principal he follows. 

    At the end of each year, a company gets to decide what to do with their earnings. Some companies issue a portion of the money to their shareholders; this is called a dividend. Most investors love it, in fact some design their portfolios to exclusively invest in companies that provide annual dividends. Warren on the other hand? He HATES investing in these companies.

    Why? When you receive a dividend, you realize gains, which means you have to pay taxes each year.

    Warren would rather the money was reinvested into the business to help it grow.

    First off, this allows him to avoid taxes for as long as he can.  But if we remember the rules of compounding, it allows his money to stay in the system and work even harder. Warren wants to be taxed only once, at the very end when the journey is over, not throughout.

    Buffett principal #2: Never take your money out

    The Aggregation of Gains

    The first rule of compounding is to start as early as you can. 

    But once your money is in, we want to optimize towards growth – this means paying as little as possible. 

    “The objective is to buy a non-dividend-paying stock that compounds for 30 years at 15% a year and pay only a single tax at the end of the period. After taxes this works out to a 13.4% annual rate of return.

    Charlie Munger, 1998

    If you invested $10,000 with Warren Buffett, at his annual rate of return of 23%, the following chart shows you the amount you’d have in 30 years, based off if you paid taxes each year versus allowed the money to keep compounding. 


    Assumes 23% compounding annual rate, blue line allows money to compound, red line removes taxes at 35% rate each year
    It’s worth noting that these are extremely high rates of return, and the average investor can expect to get closer to 8% ARR

    Breaks vs BRAKES

    Breaks are healthy – they allow us to recover and admire our results.

    Trouble comes when we allow a short break to turn into hitting the brakes (that is, stopping completely). 

    Here’s what what I mean:

    • Health – When we feel physically in shape, we decide to stop exercising – a few days becomes a few weeks
    • Learning – When we believe we’ve mastered enough, we decide to stop learning – binge reading becomes binge television
    • Relationships – When we sense our connections are strong, we decide to stop building them – personal texting becomes singular social media posting 

    Warren’s principal reminds us of the power of pausing too often or for too long.

    Once you stop showing up, you stop gaining. 

    Keep It Going

    You’ve decided to start (that’s great!), but don’t underestimate the importance of continued hustle. The laws of compounding don’t care if you’ve had a bad day, or it’s a busy week.

    When we decide to follow through, we continue to gain, period.

    So wherever you are, keep it up, and just like Warren you too will enjoy the aggregation, not of a single year, but an exponential 30 years. 

    Getting up when others won’t is what makes all the difference. 

    And who knows, that determination might be worth an extra $2.8M dollars, in whichever domain you’re compounding.

    Post inspired by:

    Buffettology: Unexplained Techniques That Have Made Warren Buffett by Mary Buffett

  • The Great Jack

    The Great Jack

    Last week Jack Bogle passed away. A true financial great, Jack made some of the most pivotal contributions to finance and investing throughout his career. Don’t just take my word for it, even other legends agree:

    “If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.

    In his early years, Jack was frequently mocked by the investment-management industry.

    Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.”

    Warren Buffet, Berkshire Annual Letter 2016

    In this writeup, I outline my favorite Jack Bogle lessons, all of them have applications outside of money management and may be applied in wider ways across your life. The quotes within are taken from, “The Bogleheads’ Guide to Investing“

    Compounding Interest

    The best gains in life grow in a compounding fashion; returns continue to grow on top of prior returns. The amounts your money can earn in Year 1 will be far smaller than year 2, year 3 or year 5.

    A comparison of two investment accounts. The first starts with $10 and grows by $1 everyday. The second starts with 1 penny and doubles everyday. The penny will be worth more by day 13, and by day 16 (shown above) the compounding account will be worth 13x that of the linear one.

    “It may not seem like a big deal, until you realize that every time the money doubles, it becomes 4, then 8, then 16 times your original investment.

    Start with one penny and double it every day, on the thirtieth day it compounds to $5,338,709.12.”

    LESSON: Most people search for linear gains. Instead, set your pursuits on investments that can yield compounding results.

    Related: The Impact of a Starbucks Latte

    Start Early

    If your young, your greatest advantage is starting earlier than your competition. “The best time to plant a tree is twenty years ago. The second best time is now.” The old proverb goes. At face-value, a few years doesn’t sound like much, until you account for compounding interest.

    If you contribute $1,000 each year into an investment account, which compounds at 7% each year, above is the final balance you’d have by age 67, based off what age you start.

    “Let’s assume a child is born today. For the next 65 years, she or her parents will deposit a certain amount into a stock mutual fund that pays an average annual return of 10 percent.

    How much do you think they need to deposit each day in order for her to have $1 million at age 65? Five dollars? Ten Dollars?

    In fact, a daily deposit of only 54 cents compounds to more than $1 million in 65 years.

    It really helps to start early.“

    LESSON: The most important thing you can do is start today. Forget about the marginal progress you’ll make on Day 1, it’s the fact that you got off the couch and began that matters most.

    Related: Ninety-Percent of life is about showing up on time

    The Power of Subtracting

    The common-person thinks the only path to wealth is to generate more income. While making more money can help, there’s a second part to the equation, one which is often times ignored: minimizing costs.

    “Reducing your spending [costs] is financially more efficient than earning more money.

    For every additional dollar of earnings you plan to save, you will likely have to earn $1.40 because you have to pay income taxes.

    However, every dollar unspent can be invested [immediately for compounding gains].”

    LESSON: While most people focus on gains, you should also consider the power of subtractions. You don’t need to add another book to your reading list, you need to remove one not servicing your needs.

    Index Fund vs. Fund Managers

    Choosing a single winner is far harder than it may appear. While markets are meant to show the “real value” of an asset, it’s nearly impossible to predict their future value. You’ll fare much better by holding the entire market; when the economy wins, you win too.

    The fastest way to get rich in the stock market is to own the next Microsoft. The fastest way to lose all your money is to own the next Enron. Identifying them in advance is impossible.

    However, you don’t have to identify them in advance to make a healthy return on your investment. If you buy an S&P 500 index fund, your investment is highly diversified and its performance will match that of 500 leading U.S. corporations’ stocks.

    Over 10 years, the average expert-picked stocks were up an annualized 8% compared to the market index return of 9.5%.

    A 1.5% difference may not seem like much, but compounded over a lifetime it makes a tremendous difference.

    LESSON: Don’t waste your time trying to find a needle in a haystack. Sure you may get lucky sometimes, but odds are you’ll fare better by holding a small piece of everything. Worry about getting the market (macro) right, not the stock (micro).

    RIP Jack, you will be missed.

  • Writing a blog is like lifting weights

    Written on March 8th, 2018

8 minute read

    Writing a blog is like lifting weights

     

    If you’re reading this article, I need to thank you.

    Thank you for becoming a fan, sharing with friends, and for all of the encouragement along the way.

    Building a subscriber base is a lot like weight lifting.

    Let me explain…

     

    The first time you hit the gym, your muscles aren’t very strong. Something as light as 25 pounds, really feels like 100.

     

     

    Well, that’s the same thing that happens when you start anything new. I’ll use this blog as an example, but odds are, you’re also working on something you’re excited about too. Take this framework and fit it into whatever constitutes as your blog.

     

    If you plot difficulty over your most ambitious goals, they get more achievable over time. It takes a while to establish a base, but once you do, the next goalpost becomes easier. Much like when you hit the gym, the first set of weights feel way heavier, but if you stick with it, your muscles build and those once heavier weights become your warm-up exercise. 

     

     

    It has this funny compounding effect; where your progress keeps doubling, yet, it continues to get easier. Your ability to impact keeps growing too. Suddenly lifting 100 pounds feels less than your original 50 pound rep on day one.

     

     

    This blog is still in its earliest infancy. We’re deciding which exercises make sense and when to fit the gym into the busyness of life. We have to zoom in really close to see the location.

     

    see: Starbucks Latte, Forward Goals, Being on Time

    A new workout plan

     

    Life is about the journey, not the destination.

     

    This past month, you’ve seen me lace up my sneakers and hit the gym. After a month of checking out the equipment, I’ve decided to put a new workout plan in place. That’s right, channeling my inner Kanye =)

     

    Monday Tidbits are staying, but I’m switching around the article content.

     

    I want to go deeper on these topics and add more visuals (similar to this week). Who knows, maybe there will be video content too or a podcast for the train ride or drive. But basically, the articles won’t come every Thursday.

     

    If you’ve enjoyed anything so far, or thought this week was cool, I think you’ll love what’s coming next.

     

    The destination may change but who cares?

     

    Changing the workout routine keeps life interesting.

     

    It’s all about the journey,

    Alex

  • Ninety-Percent of life is about showing up… on time

     

    Written on March 1st, 2018

8 minute read

    Ninety-Percent of life is about showing up… on time

     

    Compounding interest is perhaps one of the most important and powerful discoveries of our time.

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

    – Albert Einstein

     

    Einstein wasn’t just referencing money when he said those wise words; in nearly every domain of life, compounding can either make or break you. If for example, you only get 1% better everyday for a year, versus 1% worse, you’ll be over 1000% better by end of year.

     

     

    When you break it down, success is actually played at the margins; it’s about getting slightly better each day over a long period time, instead of dramatically better in one fell swoop. [James Clear on Marginal Gains]

    The classic example is saving for retirement. When you start early and stay consistent, accumulating a large nest egg becomes much easier. With an Employer Match, a 20 year old could invest as little as $5 each day to retire a millionaire by 67 (The Impact of a Starbucks Latte).

    If you imagine compounding as a Dr. Seuss-like machine, there are two ingredients going in to create varying levels of “Success” that come out the other side: TIME (when you start) and INVESTMENT (deliberate practice).

     

    Here’s the best part about it, you control both inputs. Given the first example (1% better), you can see that, if time is on your side, you actually don’t need to invest nearly as much. However, the longer you wait, the more you’ll need to catch up. If you contribute $1,000 each year into an investment account, which compounds at 7% each year, below is the final balance you’d have by age 67, based off what age you START:

    If you start at age 5, you’ll be a millionaire. Say you wait until half way through this chart (31 years old) to begin, you’d end up with a mere 17% of the total opportunity.

    Perhaps the more powerful input you control is how early you start, not how much you invest.

    Intellectual Compounding told by greats

     

    “An investment in knowledge pays the best interest.”

    -Benjamin Franklin

     

    Most people know about financial compounding, but few recognize intellectual compounding. That is, the same exponential curve can apply to your growth as a thinker, an entrepreneur, or any related skill. If we were to plot how much you push yourself to learn, we see the same 1% better trend lines. By learning everyday, you become better at learning new things and adapting to your environment; it’s not a linear relationship, but instead an exponential lift.

    “Read 500 pages every day. That’s how knowledge works. It builds up like compound interest.”

    -Warren Buffett

     

    The prolific speaker, Tony Robbins, has also acknowledged this phenomenon. When Tony started his career, he wasn’t nearly the presenter he is today. In fact, Tony says one of his co-workers was much better than him, which made Tony wonder why. What was difference between them? Did his co-worker have a gift that Tony was incapable of? Not even close. Tony realized he was only giving 1 presentation a week, whereas his co-worker was giving about 3 a week. So to be better, Tony quit his job and started giving 3 presentations a day. In about 2 months time, Tony gave the equivalent number of presentations that the other guy would give for the rest of the year.

    Tony massively elevated his deliberate practice, but he also started early. While his fame emerged after his first book release at age 28, his first job as a motivational speaker was at age 17 – a full 11 years earlier.*

    “The most important thing to do is start investing now so you can unlock the power of compounding.”

    -Tony Robbins

     

    We typically over-praise the individual versus their positive habits, environment, or commitment to growth. Whether you’re starting a business, a new job, or working towards an ambitious goal, compounding is the secret sauce that gets less attention. When we think of becoming great in any domain, we usually think about working harder and longer than the proverbial other guy. Instead, we should be thinking about starting one day earlier than ‘the other guy’.

    Timing needs a higher priority

    Working hard is the easier part; it’s not difficult to wake up an extra hour earlier or stay at the office after hours if it’s something that you find deep purpose and potential in. Figuring out when to start though, that’s hard.

    “Bookstores have an entire ‘how to’ section but not a ‘when to’ section… [Yet] timing… can be everything.”     

    -Eric Barker (This is the Time)

     

    Perhaps we can simplify this though; start now. There are probably millions of great ideas waiting to be unlocked, but we’re too afraid or too slow to start. When you understand compounding, you give timing the attention that it deserves. Successful people understand this and it’s why, when they get asked about their biggest regret, many of them answer that they wish they had started sooner.

    One of my favorite high school teachers used to say, “Ninety-Percent of life is showing up on time.” He would go on long tangents about the value of time, whenever someone arrived late to class. Ironically, we’d end up spending anywhere from 5 to 15 minutes of class time listening to him dissect the topic. To him, it was imperative to show up, but the more important point was to be on time.

    Reflecting more than a decade later, I believe he understood something much deeper about timing. If you want to be the next Mozart, you can’t wait 30 years to begin learning piano, you need to show up when the opportunity first strikes. When you’re late to start, you miss much more than just the opening credits of a movie; you miss the character development, the plot, in fact, you never reach the conclusion. Using compounding interest, a late entry could reduce your returns by 100x; that’s the chance to learn, grow, or become your best self.

    To take advantage of our total potential, we need to be on time.

     

  • The Impact of a Starbucks Latte

    Written on February 15th, 2018

10 minute read

    The Impact of a Starbucks Latte

    Every morning around the country coffee-fanatics line up in droves, waiting for that favorite cup of Joe. Not only can the wait be long, but it can be more than $5 a cup! Which should beg the question… how much does your morning cup really cost?

    On one side, we have people who get the occasional coffee every month. On the other side, we have the group that can’t go a day without their orange mocha frappuccino (you know who you are)… let’s look at the daily coffee camp.

    To start, if you’re buying a $5 cup each day of the week, you are spending $1,825 each year. If that doesn’t sound expensive enough, consider the income you need to earn to sustain this morning ritual. Using a 15% marginal tax rate, you must earn $2,098 each year. To someone who makes $50,000 a year ($24 / hour) that’s 87 hours or two weeks of working each year!

    Kicking the habit or making it yourself would put $1,825/year in your pocket – sounds simple, minus the potential coffee withdrawals. But what if we took this to the next level?

    Investing the savings into retirement accounts

     

    If you dumped that $1,825 into retirement on January 1st of each year, here’s what your estimated balance would look like over time:

    Assumptions: 7% annual rate of return, lump sum invested on Jan 1 of each year, return calculated without fees

    That’s the power of compounding.

     

    But since we’re talking about retirement, it’s only fair we discuss the employer match. Here, an employer may match the dollars you contribute towards your 401k. There are limitations to the amount they might match (check with your HR department), but let’s assume they’ll match the $1,825 dollar-for-dollar.  

    Now your investment becomes $3,650 each January 1st, and the results are staggering.

    Assumptions: 7% annual rate of return, lump sum invested on Jan 1 of each year, return calculated without fees. Employer matches $1,825, investment becomes $3,650 each year

    If a 22 year old beginning their career made this one change in their daily routine, they would have roughly $744K by age 62, and they’d break $1M by their 67th birthday.

    Saving the equivalent of a daily Starbucks latte could allow working Americans to retire on schedule. 

     

    Even if you don’t have or aren’t taking advantage of an employer-sponsored 401K or match, looking to cut a small habit is worth considering. Redirecting even a handful of dollars a day can go a long way.  It’s worth noting, the retirement problem in America is very complex. There are, of course, other factors contributing to the broader issue; but this is for the individual to consider.

    When small, everyday habits compound, they create extraordinary gains. 

     

    Habits are at the center of everything we do. Everyone has experienced this situation; you’d like to workout more often, but things come up and you never end up at the gym. Perhaps you find there isn’t enough time to get to the things you care about and love. Why? You may feel as though your decisions and routines are repetitive; like you’re driving your car on autopilot. We fail to recognize that we control the habits that we form and, thus, the direction of the car.

     

    “We first make our habits, then our habits make us” -John Dryden

     

    While not everything is within your control, existing habits can stop you from reaching your goals. Be an informed driver and decide the route you want to drive based on the conditions; not on the routine.

     

    “It’s the daily practice of all the monotonous, little, boring things like brushing your teeth that matter the most. There’s no single event. There’s no one thing I can tell you you have to do. It’s an accumulation of lots and lots of little things, which any one by themselves [are] useless, yet together add up.”  -Simon Sinek

     

    When it comes to money, turning a small expense into a small savings could make you a millionaire. The same exponential return is seen across other areas of your life.

    Want to become more insightful?

    • Read about a new subject for 15 minutes each day

    Want to raise your EQ?

    • Meditate for 5 minutes each day

    Want to become a more empathetic leader?

    • Put down your smartphone before stepping into meetings; give your reports 20 minutes of undivided attention each day

     

    Similar to retirement investing, small habit changes will be subtle at first, but  they add up and compound over time. It’s with patience and commitment to betterment, that we can achieve slow, yet incredible gains.

    What’s your Starbucks latte?

    Whichever area it falls into, it may just make you a millionaire.