Mentally our minds calculate numbers in sequential order and we like to extrapolate using the same pattern. An example of this is simple arithmetic could be 10, 20, 30 …. the next number most would guess would be 40.
The issue with investing in a lot of cases is that the investment markets don’t necessarily move in sequential orders – thus creating complexities for our normal lateral day-to-day thinking. The other issue is with the compounding of an investment return, in that numbers also don’t move in sequential order.
A classic example of this problem is as illustrated below:
The above calculator assumes that if you invested $100k and this capital grew at 10% in value each year that the investment would be worth around $732k million in 20 years time.
The interesting thing with this mathematical calculation, is that it has taken 16 years to reach $500k. However between years 16 and 20 the capital value increases from $500k to $732k in just 4 years!
The problem in understanding compounding interest is in sequential calculations. When the above investor started out they began with $100k and in the 1st year in the above example they made $10k in earnings. In the second year they made $11k. What happens then is the investor then extrapolates this data out in the sequential ordering of adding around $10k per year (give or take a couple of dollars either side). With this thinking, it would mean that they would have accumulated $200k in just over 20 years (which is $10k times 20 years plus the original capital of $100k) giving a total investment amount of $300k.
This is obviously in start contrast to the actual final result in the above example.
So when analysing patterns and sequential mathematics, investors can quickly get very frustrated as they are not seeing the immediate results from the capital. However I believe with compounding interest it certainly has its benefits it just may take some time to see it and then, like a rocket, it just takes off!
This week I was driving back from visiting a number of clients who live in country Victoria’s Gippsland area. On my way back to the office, I passed a large brown coal power plant and I started thinking about this sector…….. and in particular….. if it is a growing or declining industry?
I realised too that there is a lot of parallels between this industry and Warren Buffet’s textile investment. Let me explain….
Warren Buffet’s company “Berkshire Hathaway” started originally as a US textile mill. He has been quoted as saying that this was possibly one of his worst investments. The reason being, is that the textile industry whilst cheap at the time of acquisition, was also in a declining industry in the US. Buffet has also famously said “If you get into a lousy business, get out of it….if you are wanted to be known as a good manager, buy a good business…”
Not surprisingly, Warren Buffet eventually closed the textile mill, however kept the name as a constant reminder of his lesson.
There are a number of lessons one can learn from this experience. The first might be to act very cautiously around a cheap investment or asset. It is important that the investment has a future and a prospect for growth in the future – otherwise you may find that although the asset is cheap ,it might also be a “value trap” similar to Warren Buffet’s textile mill.
In many ways, this brown coal power factory I was passing by is in my opinion similar, to the textile industry for Buffett. At some point the alternative power sources will prove more efficient and more cost effective. In this industry it is not a matter if it will be replaced, but more a case of when will it occur. In other words it is a declining industry.
It does however raise a larger question about the investments which you might hold. Are they too in a declining sector? Most people might quickly respond stating “not mine!”, however since 1900 in the US there are only 3 companies which remain today. So I believe it is not a case of if your investments will decline, but more a case of when. Understanding the date stamp on your investments and the future prospects for growth are very important when managing your investments.