Patience, persistence pays in stock market

Power law is a functional relationship between two quantities, where a relative change in one quantity results in a proportional relative change in the other quantity, independent of the initial size of those quantities: one quantity varies as a power of another.

For instance, considering the area of a square in terms of the length of its side and if the length of a side doubled then the area is multiplied by a factor of four. Simply put, if you tweak one variable it’ll have a proportional effect on the other variable irrespective of what the initial quantity has been.

Now, let’s put this across to an athlete preparing for a track event of sprint running. When he puts efforts in training for few weeks, the runner’s endurance increases, he would also clock better than the initial periods. For a period, he would make huge improvements in the timings but after a point of time, there wouldn’t be any improvement in the speed or negligible improvements in the timing despite higher efforts. This could lead to shattered enthusiasm and motivation while also opting to bad choices of performance-enhancing drugs, etc.

And if he were to put more training hours into the regime, it could even lead to injuries and hurt. So, beyond a point the returns don’t come in the same proportion of efforts and even could start to diminish. The latter part is another phenomenon, of diminishing returns, a point where more input yields progressively less output. It could lead to negative exponents.

We’ve heard about synergy and a common example of 1+12 but equals to 11. It’s nothing but the creation of a whole that is greater than the simple sum of its parts. This is because of the nonlinear relationship, which is quite opposite to the above example we discussed where the variables respond proportionally, are more complicated. In these cases, one doesn’t need twice as much of the original value to derive twice the increase in the measurable characteristic. For example, an animal that’s twice our size requires only 75 per cent more food than we do. This means, the bigger the animal, the energy required to support decreases at a unit level.

Geoffrey West in a book nicely puts this - “the collective outcome in which a system manifests significantly different characteristic from those resulting from simply adding up all the contributions of its individual constituent parts, is called emergent behavior.” What’s that power law in investing?

Compounding - Einstein once said this as the eighth wonder of the world. One who understands it, earns it and the one who doesn’t, pays it. Daniel Pink wrote about compound interest as the most powerful force in the Universe. It builds on itself. Over time, a small amount of money becomes large. Persistence is similar. A little bit improves performance, which encourages greater persistence, which improves persistence even more. And on and on it goes. Thus, compounding is inarguably the most important model in investing. In this power law, while the amount accumulated is non-linear (exponential) while the quantum of time and investment are finite.

So, the only condition for creating wealth is to use this power law and exhibit the persistence. That’s it, the results are truly amazing and equity investing is a right avenue to experience the same. To sum up, equity investing is a bit of controlling emotions, using a bit of rationality and sticking to a plan. As long as the emotions are reined in with patience, the power law of compounding takes over to deliver one the best results.

Making money in markets is never easy as stock markets never move in one direction. The volatility is a test of persistence while only the time spent in the market decides the possible gains made from the markets. Mutual funds have in a way removed the complexity out of stock investing and thus have become seamless vehicles of wealth creation.