In the investing world, there are only a few concepts as powerful as compounding. Compounding involves reinvesting earnings (interest/dividends) from an investment, therefore adding to the principal amount, which leads to generation of more earnings in subsequent periods. It also includes holding your investments, for a longer term, which practically means that you are reinvesting your capital gains and letting it work further, giving the benefit of compounding to your investment. Over the time, this cycle results in exponential growth, where the gains accumulate at an increasing rate. This snowball effect turns small contributions into substantial wealth over the long-term. While most professional money managers often grapple with the pressure to outperform the market on a quarterly basis. The pressure to demonstrate quarterly performance and even annual performance for that matter, forces many professional fund managers to take actions which takes away the benefit of compounding. On the other hand, private equity investors have much more flexibility on the investment horizon given that they invest mostly in privately held companies and don’t have pressure to demonstrate quarterly or annual performance. They take a five-to-eight-year view and sometimes even longer and stay with the investment. Even when they take a stake in listed companies, they actively engage with the management to improve company operations and have much longer investment horizon. Individual investors have the choice to not get shackled by short-term performance benchmarks. They can think beyond the immediate and focus on long-term growth of their investment portfolio. This suggests that individuals can have the investment horizon similar to private equity funds to improve their portfolio return by making compounding work in their favour. Like private equity investments that demand patience and a long-term vision, personal savings should be approached with the understanding that time is a powerful ally. The longer money remains invested, the more impressive the results of compounding become. Starting to save early and maintaining a consistent contribution pattern to the investment account can lead to massive benefits over time. Private equity funds often invest in companies that have fallen behind but has huge potential of turning around. This offers a large gain potential to investors. Individual investors can work on building their skill sets in understanding a few sectors comprehensively which will enable them to identify such opportunities. They can look to start with the sector they are already employed in and then expand their skill sets gradually to other sectors or across the value chain of same sector. The potential gains from this method can be massive and therefore it’s worthwhile to make an honest effort. Among the strategies that mirror the core tenets of private equity is venture capital investing. Replicating the essence of venture capital, individual investors can explore the domain of small and micro-cap companies. The crux is to identify enterprises with immense growth potential at their nascent stages. Since disclosures are usually on the lower side, investors need to take a call on people running the business. They can learn from VCs how they identify visionary promoters or management teams who have strong execution skills as well. This also means that individual investors should adopt a perspective akin to that of business owners while investing in equity. This means keeping a track of the business performance and more active engagement with the management. The shift in mindset can empower investors to weather any temporary setbacks to the business and stock performance. By investing in businesses rather than isolated tickers, investors can establish the mental fortitude required for long-term investing. Venture capitalists understand that not every investment they make will lead to success. Instead, it is the impressive returns they gain from a few investments that do well that help make up for the ones that don’t work out. This important principle highlights the idea that diversification plays a crucial role. In a way similar to how private equity firms approach their investments, individual investors should also aim to diversify their portfolios. Diversification involves spreading investments not only across different types of assets, like stocks, bonds, and real estate, but also in different sectors and life stages of companies. This strategy helps to reduce the overall risk of the portfolio. Another investing strategy deployed by private equity funds is leveraged buyout. The principle can be followed by individuals in their real estate investing decisions. Be it buying property for self-residence or renting, individuals need to assess whether the additional cash flow from the property generates a higher IRR versus the mortgage rate. By strategically employing borrowed funds to participate in opportunities that offer sufficiently high and steady rental income individual investors can substantially enhance their overall gains. The incorporation of private equity principles into personal savings strategies is not exclusive to the elite, it is a path accessible to all. By nurturing a long-term perspective, embracing consistency, adopting a business ownership mindset and diversifying across assets, individual investors can effectively harness the power of compounding.
The author is Chief Executive Officer, TIW Capital. Views are personal.
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