The Infinite Compounding Fallacy

The financial planning profession has a long history of demonstrating the power of compounded growth to clients.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically compounded at a high rate.  This is supposed to enable you to enjoy a happy and comfortable retirement from your compounded returns.

The Compounding Problem

Unfortunately, there is one question that never seems to enter into the conversation.  This question is whether the historic rates of compounded growth for the stock market will continue into the future?  Many millions of people are depending on the stock market compounding at historical rates.  And the shock will be even more severe, as many people have not even considered that it could happen.  For many years, it has been assumed that the stock market can continue to grow faster than Gross Domestic Product (GDP) indefinitely.  However, that assumption may be faulty.

It is important to consider that the overall stock market can only grow if new capital is invested.  Individual stocks will go up or down in value as people switch from holding one company to holding another, but there is only one thing that can propel the entire market upward, and that factor is additional investment.  However, that additional investment must come from economic activity.  What if the investment required to continue driving the stock market is larger than the amount of economic growth?  The answer should not come as a surprise.  If the money to invest isn’t being generated by the economy, it won’t be invested, and the stock market won’t grow at its historic rate of appreciation.

The Key Compounding Factor

The growth trajectory of equity markets is built on the assumption of output to fund the incremental investments that are necessary to continue driving market values upward.  Thus, the answer to the question of what will happen to stock market capitalization is very apparent.  Unless the economy grows dramatically faster than it has in the past, there will be insufficient capital to propel the stock market values upward at previously experienced rates of appreciation.

Over time, it is not possible for the stock market to compound twice as fast as the economy.  Eventually the capital required to drive further value growth equal to past rates of appreciation will not be available.  In this way, the fallacy of infinite compounding becomes strikingly apparent.  Financial planning models have been built on the assumption that one can passively generate a rate of return significantly higher than the growth rate of the overall economy.  Over time, this assumption will prove to be faulty, and spell ruin for the traditional models of investment planning.

So what can a person do?  It’s one thing to point out the problems with compounded appreciation assumptions built into financial planning models, but it’s another thing entirely to plot out a new course that overcomes these challenges.  The truth is that this course will be different for every person.  However, there are a few guiding principals that will make finding this course much easier.  These considerations are that cash is king, and leverage amplifies results.

Cash is King

This is the oldest and most hallowed of financial axioms.  Cash stands and the fundamental basis of investment value.  The ‘real’ value of an investment is the cumulative discounted value of all future cash flows it produces.  This can come in the form of dividends from a stock or rent revenue from an income property.  When evaluating an investment based on the cash it produces, the value is easy to see.  However, if the value of an investment depends solely on selling it to somebody else for a higher price in the future, it can result in tremendous volatility and risk.  This volatility compounds if the investment does not produce any cash flow.  Thus, the paradigm of the future for investors should be to seek to compound through cash flows.

Leverage Amplifies Results

Another fundamental consideration for astute investors is the power of leverage.  This can take the form of both financial leverage and organizational leverage.  In either case, the leverage will allow you to amplify the results produced by your efforts.  In the case of financial investments, borrowing at a low rate of interest and investing at a higher rate of return will allow you to amplify your returns much higher than could be earned with cash alone.  Similarly, leverage will amplify any losses that are incurred from your investments.  This is equally true with organizational leverage for business owners.  Amplifying your time through the efforts of others will allow you to generate results if you are highly effective, or chaos if you are disorganized.

In the end, future investors will need to rely on their ability to create value.  The days of infinite compounding from perpetually escalating market values are reaching an end.  The people who survive and thrive in this environment will be the ones who focus on fundamentals and create value.  It is important to understand that every difficulty carries an opportunity.  Each person is responsible for capturing that opportunity to create the best future that they can.