FINANCIAL MARKET UPDATE 11.24.2020

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE MAGIC OF COMPOUNDING

For many investors, successful investing means outperforming the market each year. This is a monumental challenge because current stock prices represent the aggregate expectation of all participants. Trying to do better than the crowd means you must compete with every star fund manager, hedge fund titan, rocket scientist turned quantitative manager, Wall Street analyst, Nobel Laureate, and high-frequency trading algorithm on the planet. All of that time, energy, money, and brainpower applied to investing has made the market pretty efficient, meaning prices are generally close to reality. To outperform, an investor must disagree with the market’s view in a material way and must be right. Like a gambler betting on the roulette wheel, investors may win from time to time, but the odds are stacked against them doing it consistently.

Individual investors have one major advantage against the professionals, and that’s the ability to be patient. Individuals don’t have to answer to bosses, boards, or clients. All that should matter is the investment goal and the time horizon they have to get there. Long time horizons are especially advantageous because they can experience the magic of compound returns.

The chart below illustrates a hypothetical individual that invests $5,000 per month for thirty years in an all stock portfolio. Let’s assume they earn 8% per year, which reflects a conservative assumption for long-term stock market returns. This example demonstrates why patience is so important for compounding to work. The main source of portfolio growth for most of the first decade is the monthly $5,000 contribution. With the initial monthly investment returns contributing little to portfolio growth, investors may be tempted to adjust their investments to earn higher than the market’s 8% assumed return. A common approach is to concentrate on recent winners, which can potentially both increase risk, and lower future returns. An investor that is able to stick with the original plan will have to invest for roughly nine years before the monthly investment returns begin to exceed the size of the monthly portfolio contributions. From there, it’s off to the races. By year twenty, the monthly investment return is about 4x the monthly contribution, and by year thirty, it is 10x.

The above chart assumes a $5,000 monthly investment over 30 year, earnings 8% per year, compounded monthly.

In sum, the investor in this example would have made $1,800,000 in contributions over the 30 year period and ended up with a portfolio worth $7,501,476. An important take-away is that the benefits of compounding are clearly experienced at the tail-end of the investment horizon. The average monthly return during the 1st year of investing was just $222, while the average during the 30th year was $47,730. If the investor was able to expand their time horizon by just five years, by either investing at an earlier age or prolonging retirement, the average return in the final year would have been $76,462. The ending portfolio value following the 35 year period would have been $11,545,875. In just 5 years the portfolio grew by an amount that initially took 23 years to achieve ($11,545,875 – $7,501,476 = $4,044,399).

Of course, this is a simplified exercise. The stock market does not generate returns in a neat and consistent manner. In reality, stock prices can fluctuate widely. There is risk that stock returns in the future will be lower than they have been in the past on average or that returns near the end of the investment horizon will be lower (path dependency). Still, the best metric we have for establishing our future expectations is the past experience. For the past 50 years, the stock market has appreciated by over 10% per year on average. 

Successful investing does not mean beating the market. Instead, it means being patient and earning a reasonable return for as long as possible. A financial plan and an investment program built on diversification and low costs are great tools to achieve these goals. Doing so will allow an investor to benefit from the magic of compounding.

 

WEEK IN REVIEW

  • Another week, another pharmaceutical company announcing positive initial results for a Covid-19 vaccine candidate. This week AstraZeneca (in collaboration with the University of Oxford) announced its vaccine candidate was as much as 90% effective when trial participants received one and a half doses. The S&P 500 is up about 2% from the initial announcement on 11/9 made by Pfizer, however, this hides the degree to which the news has helped those industries that have been especially hard hit by the pandemic. Small and value-oriented companies have experienced a meaningful boost to share prices from these developments.
  • According to data published yesterday by IHS Markit, business activity has continued to expand based on some preliminary survey data. Improved sentiment following the vaccine news and less political uncertainty now that we are past the election appears to be outweighing the growing number of covid-19 cases, hospitalizations, and targeted shutdowns.
  • Tomorrow will be a busy day for economic data due to the holiday-shortened week. Look for jobless claims, durable goods orders, new home sales, consumer sentiment, and an updated read on inflation.

HOT READS

Markets

  • There are Some Under-The-Radar Hurdles That Could Trip Up The Stock Market Into Year End (CNBC)
  • A Record 19.4 Million Homeowners Can Now Save Big on a Mortgage Refinance, as Rates Hit Another New Low (CNBC)
  • U.S> Economic Activity Picks Up on Postelection Lift, Vaccine Results (WSJ)

Investing

  • Attention Robinhood Power Users: Most Day Traders Lose Money (CNBC)
  • A Stock Market Bubble? It’s More Like a Fire (Jason Zweig)
  • Not Your Job (Humble Dollar) Investors don’t have to try to beat the market

Other

  • Bucket List Trave is Being Booked in Record Numbers for 2021 and Beyond (Barron’s)
  • Foreign Enrollment at U.S. Universities Plunged in 2020 (Bloomberg)
  • Podcast Wars Heat Up (Axios)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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