In investing, you need to understand the importance of time
When people talk about investing in stocks, a comment often heard begins with: “The most important thing is …”
How the sentence is completed, however, varies greatly. We have heard that the most important thing is “the price paid,” “knowing when to sell,” “avoiding risk,” “having a margin of safety,” “diversification” and so on.
All of these factors are important, but only up to a point. In our view, the first step to successful investing is recognizing the role of time. This is important because to do so is extremely difficult. Time is the fourth dimension. It cannot be seen or touched. Although we live in time, in much the same way that a fish lives in water, we almost never think about it.
We cannot even really perceive time itself. We all know that a Zamboni can’t fly, but we can still visualize a Zamboni passing overhead. Now try to visualize the passage of time. You can’t do it.
And yet, understanding the role of time is essential to intelligent investing. To make sense of investment returns – yours or anyone else’s – you need to look over a reasonably long period of time. Otherwise, you won’t have a large enough data set to draw an intelligent conclusion.
How did your stock portfolio do last year? Well, the primary driver of your result in most years will be the return of the stock market for that year. Whether the market did better or worse than its long-term average for a period of one year is primarily determined by randomness. Similarly, whether you outperformed or underperformed the stock market for that one year is also largely a function of randomness.
However, the role of randomness diminishes greatly if you look at longer periods of time. Over a 10-year period, results are far more a function of skill than of luck. Nonetheless, long-term thinking is rare. When it comes to the performance of their investments, most people tend to focus on the most recent year (or quarter). An investment manager may have a fine track record over the past 10 years, but someone always asks the question, “How have they done recently?” The implication is that, perhaps by working harder, the manager can control the short-term return. When, over a few months, the stock market fluctuates downward, along with a client’s portfolio, then the manager has clearly been spending too much time on the golf course.
Just as it is difficult for us to make sense of historical investment returns in the stock market when looking only at the recent past, it is impossible to estimate likely near-term returns. (This, of course, does not discourage pundits from happily predicting the unpredictable). We are all hard-wired to think in terms of the immediate, rather than the long-term, future. However, it is only over the long run that you can predict what your investment returns are likely to be, and it is only your long-term returns that will determine whether you will enjoy a comfortable retirement.
Perhaps it is because we can neither see nor touch time that we have such great difficulty in grasping the powerful effect of compounding wealth over time. To take a simple example, if you invest a sum of money at 10 per cent for five years, you will multiply your wealth by 1.6 times. If you invest your capital at that rate for 10 times as long, you will not multiply your wealth by 16 times. You will multiply it by more than 117 times.
This effect explains why almost all the world’s great fortunes have been created by owning and holding shares in growing businesses over several decades, thereby allowing them to compound on a before-tax basis. Warren Buffett has followed this buy-and-hold approach, as have the likes of Canada’s Weston, Thomson and Desmarais families.
Perhaps, when it comes to investing in stocks, time is not the most important thing. But the effect of time on your investments is something you must understand before you can make any sense of the other factors.