Secrets Of Success: Compounding is the road to riches

This column rarely ventures outside its own chosen narrow field, and with good reason. It is hard enough to keep one's head round all the dimensions of the business of investment, which is broad enough already, without seeking to plunge into other topics as well. Behavioural finance - the study of why investors behave the way they do (which is far from rationally) - is perhaps allowed as one step out from the normal fare.

However, like many others these days, I spend a portion of my time following leads around the byways of the worldwide web and occasionally stumble across something investment-related that catches my interest and passes a simple "that seems of wider interest" test. The example that I am going to describe was prompted initially by reading a book called Just One Thing, which is an edited compilation of essays on investment by various writers. The book is edited by John Mauldin, an American investor whose free weekly e-mail "Thoughts From the Frontline" provides excellent weekly commentary on developments in the American stock market, and now, he tells me, circulates to something like one million readers every week (www.2000wave.com has more details).

Although it lacks a common theme, Just One Thing has two or three particularly interesting pieces, one of which, on the psychological flaws of investors, is written by the London-based market analyst James Montier at Dresdner Kleinwort Wasserstein, whose work I have quoted before. There is also an excellent piece by Mark and Jonathan Finn, appropriately entitled "The Triumph of Hope over Long Run Experience", which brilliantly sums up the reasons why picking funds on the basis of past performance, as most people do, is such a hazardous business.

Their conclusion, which follows that of many researchers into this topic, is that 90 per cent of most investment managers' performance is really a function of their investment style; that is to say whether the tide of value, growth, large cap, small cap, or whatever their particular approach happens to be is also running strongly in the markets over any period being measured. Just as you should never confuse genius with a bull market, as another old saying has it, so you shouldn't believe that a growth stock fund manager is a superstar just because he is investing in a period when growth happens to be all the rage.

The fact that so many investors do seem to base their actions on just such a view of the world is, the authors conclude, largely because humans in general have difficulty coping with uncertainty and "the randomness that abounds in the real world". All the phenomena that behavioural finance experts chronicle so lovingly, including the assumption that what has happened needs to have a causal explanation, stem from the psychological need we have to impose order and structure on phenomena that in truth reflect a raw state of nature.

Elsewhere in the book, though, is a piece by Richard Russell, a veteran market follower, whose "Dow Theory Letter" has been running for nearly 50 years. Mr Russell, now into his eighties, is still going strong in California (though not without intimations of mortality, it seems: in a footnote on his website, he tells would-be subscribers that his no refunds policy is to avoid leaving his heirs the awkward administrative burden of making partial refunds to many subscribers when he dies). Tracking the daily gyrations of the markets is such an interesting and stimulating job, he tells us, that he has no plans to retire.

In his piece in the book, Mr Russell emphasises for those who still don't get it that the power of compounding is the real key to achieving wealth from the stock market. In a table, he shows how an investor who makes just seven annual contributions of $2,000 a year between the ages of 19 and 25 (a total of $14,000) will end up with more money aged 65 than an exact contemporary who invests $2,000 every year from the ages of 26 to 65 (a total of $80,000).

"Compounding," Mr Russell explains, "is the royal road to riches. Compounding is the safe road, the sure road, and fortunately anybody can do it. To compound successfully you need the following. You need perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. You need knowledge of the mathematical tables in order to comprehend the amazing rewards that will come if you faithfully follow the compounding road. And of course you need time: time to allow the compounding to work for you."

There are, however, two catches. "The first is obvious - compounding may involve sacrifice (you can't spend it and still save it). Second, compounding is boring. Or I should say it is boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating."

What follows from this? In Mr Russell's view, the an-swer is to try to get time on your side. Most investors - the "little guys" in his words - try too hard. They are always impatient for the big payoff and as a result fail. "After almost five decades of investing and talking to investors, I can tell you that most people definitely do lose money, lose big-time - in the stock market, in options and futures, in real estate, in bad loans, in mindless gambling, and in their own businesses."

Reading this, and thinking it sadly all too true (memo to self: must send to my children), I took a look at Mr Russell's website www.dowtheoryletters. com. There, you can find other interesting pieces he has written. The best of them, and apparently also the most popular, is not directly about investment at all, but is called the "ideal business". Anyone starting out on a career - and wondering how to obtain both sufficient money to live and a lifestyle that will allow them to enjoy their lives as much as Mr Russell appears to have done - could do worse than read it for themselves. He is a wise old bird.