"I didn't go to the moon, I went much further--for time is the longest distance between two places."
--Tennessee Williams, The Glass Menagerie
Dear Family, Friends and Clients:
Time is an interesting concept. I like to think of it as a slow steady river that carries us from one decision to the next.1 While our gaze is intently focused on a progression of individual “nows”, the past becomes more distant, and the future containing the results of our decisions reveals itself without pause. At any given moment, we are the total of all the decisions we have made, or that have been made for us, weighted based on a function of importance over time. Our principles are based on this perspective in whole. Principle 5 is a reminder that our results are an average of all our decisions, and that each individual choice, no matter how small, will contribute to our lifetime success. Our job is to consistently make good choices through processes built on proven principles, to determine the importance and materiality of each choice, and to measure progress and results to correct faulty processes. As Warren Buffet once said: “Someone's sitting in the shade today because someone planted a tree a long time ago.” 2
When it comes to important financial decisions, it always feels like we should do something, but as Charlie Munger said: “The big money is not in the buying and selling … but in the waiting.” By designing repeatable processes, controlling our emotions, and putting the wind of time to the back of our sails, we maximize our potential to reach and surpass our goals. Our mission is complicated by the large number of factors interacting independently, our small size in relation to the whole, exogenous unpredictable occurrences, and the all too human tendency to greatly overweight the satisfaction of now over the pain of waiting for the future. Our process dictates a balance between these competing forces, establishing the needs of the future, determining a plan that provides a high probability of success, and gaining the freedom to utilize excess resources to harvest the joy of now.
The Law of Large Numbers:
At first glance, it would appear based on intuition, that the distant future should be much harder to predict than tomorrow. I can clearly determine what I want for lunch next Tuesday, but predicting where I will be, or if I will be, in 30 years is much more difficult. But instead of a single lunch on a Tuesday, let us imagine I am trying to predict the number of sandwiches I will have over a given period. Would it be easier to predict the average for a month or for the next 30 years? Given a completely random system, The Law of Large Numbers says the latter. The Law of Large Numbers is a theorem that indicates that repeating a large number of trials (decisions) will produce results approaching the expected value as the number of decisions increases. While a coin may flip heads 10 times in a row, over a billion flips we would expect almost exactly a 50% recurrence of both heads and tails. This is not to say we are in a completely random world; however, there is indubitably a modicum of randomness in all our lives. Making good decisions, repeatedly, gives us our best hope to attain good results. Our role in this is to carefully study what constitutes a good decision given the facts and circumstances, help you make the correct decision, adjust the decision over time based on new circumstances, and measure and evaluate progress to determine the effectiveness of our decision making.3
The Power of Compound Interest:
The second reason we focus on the long-term is best summarized in a quote by Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” Compound interest is what we earn on interest over time. There is a positive aspect to this reasoning, as well as a negative. The positive side is indicated by a mathematical rule called the Rule of 72. This is a simple approximation to help determine how long it will take for an asset to double given some interest rate. To determine the number of years, simply divide 72 by the interest rate, and the result is the approximate number of years to double. For instance, at a 7.2% rate of return an account will double about every 10 years.
As can be seen, during each doubling period the initial principle becomes a smaller and smaller proportion of the total account balance, so that by year 50 in this series, the principal amount is only 1/32nd of the total.
The negative side revolves around how asset price declines impact compounding over time. Consider the following series of returns, the first at 6% and the second at 12%:
So far, the second investment is clearly superior. Let’s imagine, as is often the case, that the increased annual returns for the first nine years were compensation for some infrequent, but likely, catastrophic event, and the final year return for investment 2 is a loss of 50%, while “boring” investment 1 continues to earn 6%. Now compare the series:
As can be seen, infrequent catastrophic losses can erase a decade of return; it is why our principles are focused on protecting the downside, as well as earning high returns.
Reducing Trading Costs and Income Taxes:
The third reason for thinking long-term is purely practical: the more frequently we buy and sell securities, the higher the cost both in terms of trading expenses and income taxes. Trading expenses are a frictional cost that reduces the average rate of return over time. If there is a clear reason to trigger a trading expense, then it is an unavoidable cost of doing business; however, if we are trading by mindlessly hopping from one security of dubious value to another, then we are simply reducing long-term returns based on indecisiveness. Principle 7: Careful Consideration of Costs, deals with management of expenses, and we will dig much further into this topic in a future communication.
Taxes are a similar but more impactful factor involved in managing your assets. Borrowing from the discussion on compounding, imagine a tax regime that takes 20% of profits on every sale, much like the current top capital gains rate in the United States. Let us further imagine an indecisive investor who earns exactly 10% per year, but sells everything at the end of the year (This tax regime does not differentiate between long-term and short-term capital gains):
As can be seen, the investor has given up a significant proportion of his returns due to taxes over the holding period. But to make matters even worse for our hasty investor, because interest would be earned on the annual tax bill due to compounding, the long-term results are better on an after-tax basis as well:
Next, we assume that the tax regime differentiates between short-term and long-term holdings, and charges a maximum of 37% of gains on sales on investments held less than one year:
To finish the series, and to illustrate the difference between long-term and short-term capital gains, we show the power of compound interest earned on the annual short-term tax that would be paid if we sold annually:
Based on this example, it is important that we only make sales that trigger taxes and trading costs when the alternative is clearly evaluated as having better future potential for returns.
Thinking Fast and Slow:
In his book Thinking Fast and Slow4, Daniel Kahneman discusses two different systems of thinking that we all possess. System 1, our unconscious, quick, “fight-or-flight” system allows us to react quickly when we are in danger. System 2, our conscious, slow, analytical system allows us to solve complex problems by determining the appropriate decisions given a desired outcome. The more financial decisions we make in System 1, the more likely we are to exhibit cognitive biases, follow the crowd, and fall in-line with current trends and opinions. However, if we are brave enough to rely on our conscious thought and trust in our Principles by implementing System 2 thinking in all of our financial decisions, we greatly increase our probability of success over our lifetimes. Thinking long-term forces us into System 2, and maximizes our ability to remain calm under pressure. I highly recommend this book as further reading for anyone hoping to improve their decision making.
Allowing You to Sleep Well and Eat Well:
Taking a long-term view, in the presences of good decisions, will help you be more confident in your approach, limit emotional decisions and produce significantly better returns over your lifetime. We seek to take advantage of The Law of Large Numbers and compounding to maximize our effectiveness and minimize the impact of our mistakes. We reduce frictional costs, by being patient, both in terms of expenses and taxes. There will be periods of time in which it looks like quick decisions should be made, but in our experience, this invariably turns out to be untrue when the receipts are finally counted because we will delegate to our emotions instead of employing our conscious thoughts and Principles to navigate choppy seas. Our job is to help you define your goals, develop systems and processes to help you reach your goals, and help you implement and update decisions as time passes. We will never declare victory in the middle of the game, and we will work our hardest to help you maximize your wealth when you are building it and make your financial assets last throughout your lifetime when you need them to work for you.
We wish you well during the Holiday Season. Many of us will share in family traditions, and we wish you the pleasure of spending time with people you love, and for whom your financial decisions are most important.
W. Allen Wallace, CFA, CPA/PFS, CFP®
1 Dalio, Ray. Principles. Simon and Schuster, 2017.
2 Kilpatrick, Andrew. Of Permanent Value: The Story of Warren Buffett. Andy Kilpatrick Pub. Empire, 2002. Statement of January 1991
3 Mlodinow, Leonard. The Drunkards Walk: How Randomness Rules Our Lives. Vintage Books, 2009.
4 Kahneman, Daniel. Thinking, Fast and Slow. Farrar, Straus and Giroux, 2015.