From Simple Gains to Exponential Growth in Stock Investing

Exceptional investment growth has long been synonymous with compound investing. In compounding, initially, the growth tends to be modest; but as the compounding effect accelerates, it steepens and eventually rises vertically, demonstrating the true power of compounding.

Fixed-income investment is a classic example of exponential growth, where money increases steadily through the reinvestment of earned interest over an extended investment horizon.

Can compounding growth be replicated in stock investing?

Indeed, simply investing in growth stocks with Dividend Reinvestment Plans (DRIPs) over a longer duration can accelerate compounding, primarily driven by earnings growth. However, unlike fixed-income securities, the compounding mechanism in stocks is less predictable due to the variability of dividends and capital gains.

As variability in dividends and capital gains can interrupt the compounding trajectory, potentially slowing or even reversing investment growth.

Mr. Doug Fabian, Senior Vice President at Mercer Advisors, conceptualized a tactical framework to overcome the challenges of compounding in stock investing, known as the '5/10/20 Vision' in his book Maverick Investing. 

It is a rule-based strategy aims to achieve the target return progressively by compartmentalizing it into quarterly milestones. For example, a 20% p.a. growth is broken down as 5% growth in first three months, 10% growth in first six months, 15% growth in nine months and 20% growth by year end.

Thus, it makes compounding in stock investments simple, measurable, manageable, growth-oriented, and achievable.

Illustration of Quarterly Compounding Strategy for Stock Investment:

Investment Details:

The following tree diagram illustrates a real-world application of Mr. Doug Fabian’s concept of compounding in stock investing, using an 'if–so–then' approach along a timeline.

Here is a clear and structured presentation of how an investment of Rs. 100,000 will grow over one year, assuming:

• Annualized target return = 20% p.a.
• Compounded quarterly (i.e., 5% return per quarter)
  
• Reinvestment of all earnings (dividends + capital gains) every quarter

One of the greatest flaws in the 5/10/20 Vision is its assumption of being fully invested for all 365 days of the year. This is difficult to maintain, especially when the strategy requires divesting from a stock that fails to deliver a 5% return in a given quarter. 

The effectiveness of this strategy hinges on:

• disciplined execution—such as buying a stock only when there is a reasonable expectation of achieving at least 5% capital gains in the next 3 months, particularly when no dividend is expected.
• Investment must be made in stock offering stable or growing earnings over the investment horizon and beyond.
• Investment only in highly liquid stocks 

Final Word:

For potentially above-average long-term returns, investments should be made in stocks with a track record of consistently surpassing the quarterly target return.   

Remember

Compounding is the eighth wonder of the world. He who understands it, earns it... he who doesn’t, pays it