The most powerful force in investing
An often-overlooked part of a great investment (business) is the duration of growth. Wall Street is obsessed with measuring (1) return - typically over a one year period and (2) risk - typically defined as price volality.
Why is that? Bonuses are paid annually. Higher return = bigger payout. Lower risk (volality) = more likely of a payoff. But if you are looking to build wealth you need to focus on duration.
A stock chart that looks like this = duration at work
Chart 1: The Power of Duration
A $100 investment growing 8% per year
Finance 101 tells us:
Typically, this formula is utilized to figure out the future value "FV" of an interest bearing investment. It allows you to figure out how much your investment will grow over time based on (1) the initial investment "PV", (2) the interest rate "r", and (3) the duration of the investment "n".
The formula also applies to stocks, but is often not
Equity investors rarely apply this formula. They are too focused on stock price performance over a one year time period. That compares to interesting bearing investments which in many cases have fixed fixed returns (interest rates) over the life time of the investment.
An old adage, "in the short term the stock market is a voting machine but in the long term it is a weighing machine." Over the long term, cash flow growth on a per share basis is what drives equity performance. Therefore, you can replace "interest rate" with "cash flow growth on a per share basis."
Equity investors can break the formula down
If n = 1 year, the formula is:
If n = 2 years, the formula is:
If n = 3 years, the formula is:
And so on…
A consistent growth rate over the hold period collapses the formula back to the orginal Finance 101 equation:
Math 101: Duration is the exponential driver of wealth
Return is earned on both the initial investment and the accumulated growth from prior years. A consistent growth rate over a long period of time is often more powerful than a short burst of extremely high growth.
Do not get tricked by Wall Street Analysts pitching a stock expected to grow earnings by 50% in the year ahead.
Always ask, what is the duration of growth?
To illustrate this point, imagine two investments:
- Investment 1: 8% growth forever
- Investment 2: 50% growth in year 1 and year 2 followed by no growth thereafter
Chart 2: Duration vs. High Growth
A $100 investment growing 8% forever vs 2 years of high growth followed by no growth
