Investing For Babies (Or: How To Compound) (2024)

Investing is certainly nothing for babies (as this might imply it is easy) but investing for actual babies is not so difficult. Starting early when investing for retirement (for example, when the person is still a baby or small child) is a clever thing to do as we have one extremely valuable asset on our side (and it is actually difficult to exaggerate how valuable it really is): time.

In times where people dream of becoming rich within months it might sound stupid to talk about decades, but that is actually the way to get rich: investing over several decades. And why is it smart to invest for 60 or 65 years (our baby investing for retirement case)? Because we can profit from something that was called the eighth wonder of the modern world: compound interest.

Lack of Imagination

While almost everybody can imagine getting rich quick (by winning the lottery or Dogecoin "going to the moon"), almost nobody seems to be able to get the true power of compound interest. You, the person reading this, probably knows about the power of compound interest and as investors calculating discount rates and intrinsic values or looking at the revenue growth of companies in the past decades, we are trained a bit on how compounding works.

But most people seem to be unable to imagine the effect of exponential growth. That is actually one of the big lessons for me from the COVID-19 pandemic. Again, and again, people were not able to imagine how quickly a few COVID cases could become a real problem. Millions of people obviously had huge troubles to image how just 15 COVID-19 cases in the United States would not go to zero as the former president predicted, but actually grow to 1,000 or 10,000 or even 100,000 cases a day very quickly. At the end of September 2020, German Chancellor Angela Merkel predicted 20,000 cases until Christmas in Germany and most people probably thought she was insane - Germany had about 2,000 daily cases back then and the exponential growth was obviously not visible for the laymen. But I probably don't have to mention that Merkel was right, and Germany hit 20,000 daily cases only 5 weeks later - at the beginning of November.

And the same is true when trying to explain to people that only a small amount invested over several decades might turn into a small fortune. If we invest $50,000 at the birth of a baby, that should be able to retire after 60 years and if we assume 5% annual growth (already including the necessary adjustment for inflation) - how much money do we have 60 years later? When you ask people that question some might say $100,000, others might say $200,000 but very seldom you hear the actual amount: $933,959.

I actually used 5% annual growth as I consider it a reasonable growth rate after the necessary adjustment for inflation. But we also know that we have to deal with money illusion and already adjusting for inflation is way too complicated. Hence, we should rather calculate with 7% annual growth (and ignore that one dollar today is not one dollar in 60 years). This would lead to an amount of $2.9 million - an amount people usually don't believe when you tell them. But they actually do believe they can win $3 million playing the lottery (with odds of 1:140 million - at least for the German lottery).

Start Investing Early

The lesson here is pretty simple: Start investing early! If you have kids, start investing early for your kids (if you can). And you don't have to invest $50,000 right away (or at birth) as this is a lot of money many parents don't have. Start small and increase the invested amount over time. For example, if you invest $500 a month, you will have invested $50,000 when your kid is 8 years old, and you still have 52 years remaining in which you can profit from the effects of compound interest on the full $50,000 I used in my example above.

A Few Rules

When investing for such a long time, we can just pick the S&P 500 (SPY) or Dow Jones Industrial Average (DIA) as solid investment. But first of all, that is boring, and it would not be necessary for me to write the article. And second, the S&P 500 as well as Dow Jones Industrial Average is so overvalued right now that picking individual stocks at this point does make sense. Therefore, we are trying to build a portfolio, which is following a few simple rules:

1. Although stocks with higher dividend yields are part of this portfolio, the main focus is not to create a passive income now but invest in businesses that will outperform over the long run (and many of these businesses will start paying a dividend maybe in a few years or a decade from now).
2. As mentioned above, this should be for a person that is decades away from retirement (most preferably a small child or baby) and doesn't need the money in the next few decades.
3. The portfolio should be built in a "buy-and-hold-forever" style and therefore it is extremely important for us to pick high-quality businesses with a stable business model and a wide economic moat around the business.
4. The basis for all my investment decisions is still the fundamentals of a business. Especially when investing for the long term (one decade or longer), investments should only be based on fundamentals as fundamentals will determine the long-term success of a business - and therefore also the performance of the stock.

Four Categories of Assets

In the following sections, I will present four different categories of assets (entirely stocks) that could be a great long-term investment for different reasons.

Category I: High Growth, Reasonably Valued

This is probably the best category for the long run. It is including those companies that have the potential to really outperform over the next decades and also have the potential to grow in the double digits over several decades. And what is making these companies (and stocks) so interesting is the fact that the valuations of these stocks can still be described as very reasonable. If these companies should be able to keep up the current growth rates for several more years, we are looking at real bargains. But even if growth rates slow down - which has to be expected - these stocks still seem to be reasonably valued.

That is actually one of the huge advantages when investing over the really long term. We can even pick companies that seem to be a bit expensive right now and that face the risk of rather huge setbacks but will most likely outperform over the long run. And when investing over 60 years, a potential underperformance of the stock for a few years is not so problematic.

Category II: High-Quality And Expensive

A second category of stocks is including rather mature businesses that performed stable for several decades (in most cases). While we don't really know how long the companies in the first category can keep up the high growth rates, we can be pretty stable that the companies in this category can perform with a similar pace as they have in the past (often for several decades). Due to the wide economic moat and the underlying growth of the sectors in which they operate, these companies are in most cases able to grow the bottom line in the high-single or even double-digits.

However, these are also stocks trading for extremely high valuation multiples, which is making extreme setbacks and an underperformance in the next few years very likely. As I have demonstrated in my past articles about Starbucks and Nike, it is problematic when investing at the completely wrong time - but only when investing with a timeframe shorter than 5-10 years. When investing for several decades, it might be still annoying when buying at the completely wrong time, but it is not so problematic when picking the right (meaning high-quality) companies.

Almost all of the above-mentioned companies suffered huge setbacks at some point during the last decade (NVO declined 72%, MCD declined 74%, NKE declined 75% and Graco even 88%), but they outperformed in an impressive way over the long run.

Category III: High-Quality And Undervalued

Additionally, I will also include companies that appear to be undervalued right now - despite the business having a wide economic moat and performing very stable. These are companies that could actually outperform over the next few years as the current stock price doesn't seem to be justified by the fundamentals these companies are reporting.

On the other hand, these are companies that often can't grow with such a high pace as the companies in the first two categories. Therefore, it seems likely that these businesses will outperform over the next decade, but might lag the other companies over several decades to come (of course, we really don't know what will happen in two or three decades from now as predicting the future for 2050 or 2060 is impossible).

Category IV: Banks

Right now, almost everybody is talking about inflation and the big discussion right now is about the question if inflation is here to stay or if the comparably high inflation rates we are witnessing right now are only a temporary phenomenon. To be honest, I don't care much about inflation at this point, I rather care about interest rates. But the two usually go hand in hand - not literally of course, but nobody can deny the correlation.

In this fourth category, I will look at those companies that will profit from higher interest rates - banks. In the last few years, banks have not been one of those investments that got people exited and during the last decade banks have not been as profitable as they used to be in the past. And while several investors seem to be convinced that banks will never be as profitable again as they were in the past (due to fintech and increased competition) I would rather argue that banks are here to stay and with interest rates increasing again banks will be extremely profitable in the decades to come. And due to the low expectations, most stocks are trading for P/E ratios in the low double digits, which is extremely cheap.

Assets to Avoid

When looking at the stocks and companies mentioned above (especially category II) you can see that I am also willing to invest in companies that are trading for a very high valuation multiple. Over the long run, quality is more important than valuation and the longer the investing timeframe gets, the more important the quality (and ability to grow with a high pace) becomes. And valuation multiples get less important if the timeframe expands.

However, there is a red line I am not willing to cross. And in that category belong several hyped stocks of our time. I am not willing to invest in stocks that are trading for a price-sales ratio of 40, 50 or 100 while the business still has to prove it can grow with a high pace over a long time. And we all know the stocks and companies that belong in this category as these are the names everybody knows: Tesla (TSLA), Palantir Technologies (PLTR), CrowdStrike (CRWD) or Snowflake (SNOW) would be some of the companies, which come to mind.

And as long as we are talking about assets to avoid, we also have to mention cryptocurrencies (or NFTs - is that still a thing?). One could argue that over the long run (several decades) we can try to invest a small amount in cryptocurrencies and if the fantasies of prices "going to the moon" play out we could profit - and if not, we lost only a small amount. And to some degree, it might sound reasonable to invest a small amount in Bitcoin (BTC-USD) for example. But one of the rules (see number 4) was to invest based on fundamentals and I see no fundamental reason to invest in cryptocurrencies. Bitcoin and the other cryptocurrencies like Ethereum (ETH-USD) or Dogecoin (DOGE-USD) have no value and no utility and we are only betting on cryptocurrencies one day replacing the currencies we know.

Should I Buy Now?

In the past few quarters, I have always been cautious about the stock market in general. From a fundamental point of view, the US stock market is extremely overvalued and there are only a few real bargains and the number of stocks that seem to be fairly valued is constantly decreasing. As I am learning more and more about sentiment, animal spirits and the importance of narratives and stories, I am also considering the possibility of the stock market moving even higher in the next few quarters (like Avi Gilburt writes in his articles based on Elliott Wave Theory).

But even if the S&P 500 (SPY) and Dow Jones Industrial Average (DIA) can climb higher over the next few quarters - investing right now with a time horizon between five and ten years is still a horrible idea and will most likely generate losses. And therefore, the question, if we should buy now (even if it is for the very long term) or better wait a few years is a legitimate question.

(Source: Advisor Perspectives)

Right now, the S&P 500 is trading for a CAPE ratio of 36.5, which is the second highest CAPE ratio in history - only exceeded by the Dotcom bubble in 1999 and 2000. And while the predictive power of the CAPE ratio for the next few quarters is very limited, the CAPE ratio is telling us a lot about the returns in the next 10 or 20 years: investors won't make profits and most likely will lose money over the next ten years.

Considering these facts, we seriously have to ask the question if investing right now for the long term is a good idea. And there are actually two answers: Yes and No.

• Yes, because over the long term (in our case 6 decades), a drawdown over the next 10 to 15 years won't matter much. I showed this when talking about the different stocks in the second category.
• No, because it makes a huge difference if we are buying the stock right now or maybe with a discount of 50% (or maybe even 75% or 90%).

And although we don't know what will happen in the next few years, we can assume that we will be able to purchase many stocks for cheaper prices than they are offered to us right now. History is actually telling us that investing won't be much fun over the next 10 to 15 years as we are headed towards another "red phase" (see chart below).

(Source: TradingView)

When looking at the chart of the S&P 500 over the last 150 years, we see that phases of very bullish momentum are followed by long phases or corrective behavior (in which investors hardly made any money). Right now, we are still in one of the bullish phases, but we have to question how long this bullish phase will last. And following that bullish phase will be another major correction that might last another 10, 15 or even 20 years.

Conclusion

Although we can take higher risks when investing for the long run (in our case: several decades), we should still avoid those "investments" that are either completely speculative - like Dogecoin - or are so extremely overvalued that even if these companies will become dominant players, the stocks are still a horrible investment - like Tesla.

And although I continue to invest when I find companies and stocks that seem fairly valued or are undervalued, I am moving very cautiously. I am mostly buying companies from category I and category III and I also own one banking stock - Svenska Handelsbanken. But I completely avoid stocks from the second category as I am very confident, I will get these for cheaper prices in the quarters and years to come. And I could also imagine being offered many stocks from category I and category IV for cheaper prices - but I don't know for sure.

Daniel Schönberger