I Prefer to Keep Things Simple

You've probably heard the story about the guy who invented the game of chess.

It goes like this: An inventor brought his chess board to the emperor of China, who was so impressed he offered to grant the man one wish. The inventor had a simple wish: He requested one grain of rice for the first square on the board, two grains for the second square, four for the third, eight for the fourth, and so on. Sounding like a modest proposal, the emperor agreed. But filling the chess board's last 10 squares would have required 35 quintillion grains of rice – enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

While I doubt the story is true, its message is important to understanding the power of compound interest: When things grow exponentially, gains look tiny at first, modest in the middle, and then -- very suddenly -- they shoot utterly off the charts.

The key to making compound interest work is sticking around long enough to make it to the end of the chess board. That's where the massive gains are. It's why, of Warren Buffett's $63 billion net worth, $62.7 billion was added after his 50th birthday, and $60 billion came after his 60th.

You can apply this same logic to individual companies. My friend Patrick O'Shaughnessy recently calculated the average annual returns of all major sectors over the last half century:

Consumer staples – food, tobacco, and household goods – win. Technology loses. Consumer staples also produced some of the lowest volatility, while technology stocks were the most volatile bunch.

There could be all kinds of explanations for this table. Patrick notes that consumer-staple companies tend to have strong brands and moats that prevent newcomers from encroaching. Valuations could also play a role. So could luck.

But here's an explanation I find persuasive: Innovation is awesome, but it's hard and risky. Companies that are required to constantly change are constantly going out of business, and for each success story there are countless and constant failures. Boring companies like food and beer require little change. They just plug along quietly, selling the same products year after year. That sounds dull, but they are the ones most likely to survive long enough to make it to the end of the chess board. And the end of the chess board is where things start getting ridiculous. 

The single best stock to own of the last 50 years was cigarette giant Altria (NYSE: MO  ) . Its stock compounded at an average of nearly 20% a year for half a century – enough to turn $1,000 into more than $8 million.

The last 50 years was the era of technology, when the world went from abacus to iPad. Yet the single best company to own sells the same product today as it did 100 years ago. Part of this is because Altria is a successful company, of course. But its secret is that it's been a modestly successful company for an immodest amount of time. Lots of companies earned 20% annual returns for shorter periods of time, but Altria has earned them for decades. That enabled compound returns to go from impressive to extraordinary.

Investors have a tendency to go for the highest growth today. Some can invest that way successfully over long periods of time. But the more an industry changes, the harder it is as an investor to consistently bet on the ride side of change. I prefer to keep things simple. I like companies that sell the same thing today as they did 50 or 100 years ago. Food, household goods, those kinds of things. These companies are boring today, but they're more likely to be alive twenty or thirty years from now – all the way to the end of the chess board.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

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Read/Post Comments (14) | Recommend This Article (66)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 18, 2014, at 4:04 PM, djlaino wrote:

    My dad use to teach us a similar lesson as kids, trying to convince us to "just" pay him a penny today and double it each day for just a month, rather than pay the $5 or $10 or whatever that we owed at the moment. It turns out in just four weeks the payment alone would amount to almost $2.7M! The sum of the payments up to that point would be double that amount. Powerful indeed.

  • Report this Comment On July 18, 2014, at 5:00 PM, LennyTheFool wrote:

    It's powerful... if the % is high enough. There's a huge difference between 9% and 13% after 50 years (like a 6-fold difference), but 20% for 25 years is better than 9% for 50.

  • Report this Comment On July 18, 2014, at 5:09 PM, HectorLemans wrote:

    I really like Church & Dwight (of Arm & Hammer baking soda fame) for this very reason - modest but constant growth year after year; decade after decade.

  • Report this Comment On July 18, 2014, at 5:22 PM, TMFVelvetHammer wrote:

    >> Innovation is awesome, but it's hard and risky. <<

    Great way to put it, Morgan. I think it gets back to Peter Lynch's concept of "buy what you know."

    Of course, there are two parts of this concept: Part one is having some sort of skill set, training, or inside advantage that creates an advantage versus the average investor, allowing one to find the best potential outsized returns in a particular sector or industry or niche.

    The reality is, 99% (or more) of us don't have that advantage in any area -- despite what we may think -- which is where Lynch's precept carries over into the second part, i.e. buying what we know in popular and durable consumer brands. Sounds like the data backs that up as a reasonable way to invest for the long term.

    I know this isn't **exactly** what Lynch wrote about, but I think it's pretty close. Most investors spend their time making guesses, and guessing -- if not totally wrong -- then not exactly right, either.

    Jason Hall

  • Report this Comment On July 18, 2014, at 5:50 PM, anindakumars wrote:

    Hi Morgan,

    While I get your concept of compounding (longer = greater growth), using exponent function to explain compounding is faulty if not misleading.

    Even with a high annual growth rate of 10%, it would take 6 years for compounding to double your money, whereas it would take 1 year with exponential growth (in the chess example you cited). For compounding to equal exponential growth your stock needs to return 100% growth per year!

    Makes sense?

  • Report this Comment On July 18, 2014, at 9:52 PM, jlclayton wrote:

    Terrific article that illustrates the point that starting small, but investing consistently over a long period of time, can lead to huge returns.

  • Report this Comment On July 18, 2014, at 11:01 PM, TerryHogan wrote:

    @anindakumars

    You're kind of proving the quote that opens the article. Exponential growth is growth of the form: xt = x0(1+r)t

    (the first t and the 0 should be subscripts, and the second t is an exponent)

    Basically, compounding is exponential growth. In the chessboard example the rate of growth is 100% (or the r in the above equation is 1). An annual growth rate of 10% for a number of years is still exponential growth, the only difference is that the r in the equation is 0.1. If you experiment with the equation you will see that even if the rate r is small you can make x infinitely large as long as you make t large enough. Basically, even if the (inflation adjusted) growth rate is low, if you can wait long enough you will have a lot of money. If you could live forever, you should have no excuse not to be a trillionaire, though I guess the tough part is not touching it for all those centuries, or investing in tulips.

    It's interesting to look at the purchase of Manhattan from this perspective, if you were to assume a compound annual growth rate of about 7% on the purchase value it looks like a fair deal.

  • Report this Comment On July 19, 2014, at 3:00 AM, butchokoy wrote:

    Love the article. My portfolio has growth and compounding on my side. I have WFC, USB, BAC, V, MA, GE, IBM, AXP, KO, PEP, MCD, PG, DEO and WMT. I consider both Visa and Mastercard as growth stocks. My wife and I also have Vanguard 500 Index in our retirement account. Hopefully, this will take care of us going in to retirement.

    Do you have any plans on selling PM or MO? A lot of people say it's a shrinking industry and government regulations and taxes might kill the companies.

  • Report this Comment On July 19, 2014, at 1:18 PM, n8larson wrote:

    @butchokoy: I'm not Morgan, but have owned both stocks in the past. The 'shrinking industry, government regulations and taxes' have basically been three legs of the Altria short thesis stool for about 35 of those 50 years (a 4th might be a socially responsible investing' leg). Consider also that listening to what "a lot of people" say is what makes "a lot of investors" lag the market.

  • Report this Comment On July 19, 2014, at 6:08 PM, Mathman6577 wrote:

    As Warren Buffett once said on why he hasn't bought a tech stock and instead loaned Mars Inc. money so it could buy out Wrigley: "In 20 years there probably won't be an iPhone but there probably will be chewing gum".

  • Report this Comment On July 19, 2014, at 11:40 PM, jjmaiers wrote:

    Why ignore the elephant in the room? Altria makes a highly addictive product that has killed hundreds of thousands of its customers over the decades. It might well have been a great investment but it seems to me it is a highly immoral company and I hope its victims are successful in suing it out of existence.

  • Report this Comment On July 20, 2014, at 9:38 AM, TMFHousel wrote:

    The moral issue of owning Altria is real and I respect everyone's opinion. I just think it's morally inconsistent to think Altria is a devil while companies that sell its products (Costco) are ethical bastions, and companies whose products directly lead to obesity/diabetes (Coke/McDonalds) are American icons.

    Author Dan Pink made a great point recently: The problem with conscious capitalism is that everyone gets to pick their own definition of what conscious is, and more often than not they're fooling themselves and ignoring counter-examples that go against their views.

  • Report this Comment On July 22, 2014, at 12:28 PM, hbofbyu wrote:

    How to find moral consistency? My commute this morning was immoral because of the CO2 from my car's exhaust. Israeli behavior in Gaza is a collective war crime. There are unpleasant truths we don't want to know about who we are. Maybe to alleviate cognitive dissonance we take up other causes. Everyone has a need to feel morally superior to someone.

  • Report this Comment On August 14, 2014, at 10:54 AM, unoporunoesuno wrote:

    These are the network marketing business basic principles.

    Working alone: 1x1=1 EVER !

    But if you duplicate your business unit: 1x2=2

    Once again: 2x2=4

    And again: 2x4=8...

    And so on.

    But, why use just 2 ?

    Why not use 3 or 4... ?

    No limit !

    Hard work, patience and long term results.

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