The Joys of Compounding

Published on June 1, 2020

“Your beliefs become your thoughts. Your thoughts become your words. Your words become your actions. Your actions become your habits. Your habits become your values. Your values become your destiny.”

— Mahatma Gandhi

The school of hard knocks provides everyone with life lessons, whether we like it or not. Tuition is payable not in dollars or gold or bitcoin but in the more indirect form of opportunity cost. It is the nature of the world to inform us when we act without knowing what we are doing, and that information often comes at a high personal cost. Some things in life can only be understood through personal experience but much can be learned vicariously, and if we pass up such opportunities, we needlessly subject ourselves to paying more “tuition” than necessary.

Learning vicariously through the wisdom and mistakes of others is surprisingly uncommon given the vast benefits that can be obtained in exchange for investing time and effort in the process. The best information available to humanity is either free or very inexpensive compared to the benefits of knowledge. The cost of formal education has continued to skyrocket in the twenty-first century while the cost of information on the internet has continued to plummet. For a tiny fraction of the cost of a year of university tuition, one can purchase the Great Books of the Western World and have plenty of money left over to see the world as well. Best of all, this type of education is not dry and boring but exciting and adventurous.

When it comes to investing, the best MBA program is free of charge and the wisdom found in a core collection of investing classics can be purchased for a few hundred dollars or borrowed for free at the library. In addition to the “core education” provided by these classics, numerous books are published every year that provide the thoughts and advice of contemporary investors who offer their life experiences to the reader. Gautam Baid’s new book, The Joys of Compounding, is destined to become a must-read investment classic. Baid does an excellent job of taking several steps back from financial analysis and relating how his life story shaped who he is as an investor, how seeking a broad-based education and the “worldly wisdom” that comes from it formed his intellectual foundation, and only then describing how this has translated into financial independence through intelligent investing. It might sound like a cliché, but value investing is more than a profession. It is also a lifestyle.

Especially during times of high volatility, which has certainly been the case so far in 2020, stock markets gyrate in ways that make it seem as if the people doing the trading are absolute lunatics. Novice investors often look at the overall state of the markets and assume that the obvious presence of speculative lunacy means that it ought to be easy to “beat the market”.

Of course, nothing could be further from the truth!

The ability to beat the market in any meaningful way over a sustained period of time is hard.

Very hard!

The vast majority of investors utterly fail to beat a passive strategy of simply owning a low-cost index fund.

Why is this? For one thing, by definition, it is impossible for the average investor to outperform the market averages and when you add the often invisible frictional costs of trading, the average investor is sure to lag the overall market.

It is not enough to be smart and follow the news. Everyone does that, and there is no advantage to merely doing what everyone else is doing. To start off an investment book by diving into financial statement analysis is putting the cart before the horse.

Self-Improvement and Worldly Wisdom

Baid starts his book by pointing out that self-improvement is the best investment anyone can make. Investing in your own intellectual and emotional development is not only a pre-requisite for investing success but also necessary to live a complete and full life.

In a world of constant context switching, achieving a state of flow is essential, and one must understand the horrific cost of wasting even a single hour:

It is essential to understand the opportunity cost of this one hour. On one hand, you can indulge in getting dopamine-laced rushes from emails and social media feeds while multitasking. On the other hand, you can dedicate the time to deep work and self-improvement. An hour’s time spent acquiring in-depth knowledge about an important principle pays off in the long run. This current investment is minuscule compared with the significant net present value that results over a lifetime. It is akin to buying a dollar for less than one cent. This is why good books are the most undervalued asset class: the right ideas can be worth millions, if not billions, of dollars over time.

The Joys of Compounding, p. 6

In what ways should we seek out self-improvement by investing in ourselves?

Clearly, some focus is important here and Baid draws heavily on the concept of “worldly wisdom” that is most associated with Berkshire Hathaway Vice Chairman Charlie Munger. Munger’s advocacy of learning the core principles of mental models in various disciplines while avoiding the most common psychological pitfalls has helped countless value investors in recent decades. Farnam Street’s mental model book series and Poor Charlie’s Almanack are great resources to draw upon. Baid also does an excellent job of providing key quotations from Buffett, Munger, and many others driving home the importance of a multi-disciplinary mindset.

The reason we cannot succeed as investors by taking a purely quantitative approach and ignoring human nature is because financial markets are social constructs that are driven by human beings subjected to the entire range of human emotions. To attempt to understand financial markets without understanding human psychology and the fundamentals of mental models would be like trying to understand a hard science such as physics without first comprehending the underlying mathematics. Financial markets are more than numbers and equations and the first step is to understand how human beings think.

Many economists and market seers engage in “physics envy” by attempting to reduce human behavior and market action to a set of equations, usually littered with Greek letters and often resorting to higher mathematics.

Don’t be fooled.

As Warren Buffett has pointed out repeatedly, basic arithmetic is all that is needed to succeed as an investor and, since most of us learn this arithmetic before entering high school, the place to focus when it comes to gaining a competitive edge resides in the great mental models of other disciplines.

Humility and Good Karma

“When you get to my age, you’ll really measure your success in life by how many of the people you want to have love you actually do love you.”

— Warren Buffett

Do you need to be a good person with a sense of humility to succeed in business and investing? An honest answer would be that there are plenty of examples of terrible people with poor ethics who seem to do quite well in terms of building their net worth. Most of us probably know at least a few people in this category. If your only goal in life is to accumulate wealth, it would be naive to suggest that the only path to a large bank account is to be a good human being.

For some reason, the value investing community seems to broadly reject the notion of pursuing wealth as the sole objective in life. This is not to say that value investors are not driven by the pursuit of wealth. Clearly Buffett, Munger, and probably most of you reading this article are driven by the desire to be wealthy. Baid relates his personal story and how he was driven to reach financial independence but, like many others, takes a more enlightened approach when it comes to how wealth fits into a broader notion of a life well lived.

Baid devotes a large portion of his book to self-improvement and the need to build and sustain good character. He regards these efforts as worthwhile for their own sake but also recognizes that traits of people who constantly strive to improve also tend to lead to insights that can compound into great wealth. For example, the ability to be humble is a mindset that allows us to be open to new ideas and opinions. Arrogance, on the other hand, closes our minds to alternate ways of seeing the world and can blind us to views divergent from our own best-loved ideas:

The deeper one dives into any field, the more humble one generally becomes (also known as the Dunning-Kruger effect). By demonstrating intellectual humility and acknowledging what we don’t know, we place ourselves into a beneficial position to learn more — thus, the dawning of wisdom. True expert knowledge in life and investing does not exist, only varying degrees of ignorance. This is not a problem to solve; it is simply how the world works. We cannot know everything, but we can work hard to become just about smart enough to make above-average decisions over time. That is the key to successful compounding.

The Joys of Compounding, p. 52

People who approach life with a sense of humility and seek to broaden their worldly wisdom often find serendipitous opportunities through interactions with like-minded individuals. In many ways, the value investing community fosters this type of good karma. The nature of being generous with your time and insights is that you never receive a direct benefit from doing so immediately. And the truth is that you may never receive any tangible benefit. However, over a long lifetime, you have a much greater chance of good things happening to you through “luck” that really had less to do with luck than with good karma built up by being a decent human being.

Nuts and Bolts

You cannot hope to succeed as an investor without achieving fluency in the field of … investing!

Understanding the great mental models of other disciplines is necessary but not sufficient. To be a great investor, one also needs a solid process and a circle of competence in one or more areas that provides variant views on investable securities.

Nuts and bolts are a critical part of any investment book. Baid presents several ideas in his sections on common stock investing and portfolio management that helps to illuminate his evolution as an investor. The nature of this business is that every investor’s path is different because we all bring to the game different sets of interests, varying backgrounds, and our unique temperament.

Baid’s familiarity and experience with the Indian economy is apparent throughout these sections and many of the specific examples and case studies he presents are of names that may not be familiar to American investors. This can actually be viewed as a positive aspect of the book in the sense that investors unfamiliar with the Indian stock market are exposed to companies that they would otherwise not read about. Obviously, reading this book isn’t sufficient to invest in Indian securities, but perhaps some readers will be inspired to learn more. As Baid points out, India is a fast growing economy sure to have many winners in the decades to come.

It is also interesting to note that Baid has clearly internalized the benefits of long-term investing but is not averse to taking advantages of opportunities that he perceives in shorter term commitments. The chapter on commodity and cyclical stocks is interesting because the timeframe for holding such investments is measured in weeks and months rather than years and decades. Baid achieved financial independence through his “tryst with commodity investing”. The case study he presents is in an area that many value investors might shy away from but actionable insights are rare and valuable. Baid felt that he had such an insight, acted on it, and achieved financial independence as a result.

The Essence of Compounding

It is fitting that Baid concludes his book by discussing the many different types of compounding that exist in life. Understanding the exponential function at the heart of compounding money is, of course, essential, but similar functions exist in many other areas of life.

Baid believes that compounding positive thoughts, good health, good habits, knowledge, and goodwill all have enormous benefits in life that go well beyond money. But the fact is that the side effect of compounding in these areas can also lead to compounding wealth.

Indeed, value investing, viewed in this way, is more than an investing approach but also constitutes a lifestyle, a way of living that puts the odds in your favor and is also worth pursuing for non-monetary reasons.

Baid’s book reminds me of another investing classic, The Education of a Value Investor, by Guy Spier which I reviewed in 2014. Spier also presented a highly personal account of his evolution as an investor. The best books on investing go beyond financial statements and Baid and Spier both do a great job of providing this broader context.

Disclosure: The Rational Walk LLC received a review copy of The Joys of Compounding from the publisher.

The Joys of Compounding