an article from a fund manager but so important to revisit.
- Compound interest is an
investor’s best friend.
- The higher the return, the
greater the investment contribution and the longer the time period the
more it works.
- To reap maximum advantage
from it, ensure an adequate exposure to growth assets, contribute early
and often to your investment portfolio and find a way to avoid being
thrown off by the investment cycle.
Introduction
I reckon
the first wonder of the investment world is the power of compound interest. My
good friend Dr Don Stammer even goes so far to refer to it as the “magic” of compound interest because it
almost is magical.
Compound interest can be the worst nightmare of a
borrower as interest gets charged on interest if it is not regularly serviced.
[Probably why bank share calculations are so high as borrowers cant or wont reduce their debt ]
But it’s the best friend of investors.
Unfortunately for a variety of reasons some miss out on it.
Compound interest – what is it?
But what
is it and why is it so powerful? Compound interest is simply the concept of
earning interest on interest. Or more broadly, getting a return on past
returns. In other words any interest or return earned in one period is added to
the original investment so that it all earns interest or a return in the next
period. And so on. Its best demonstrated by some examples.
- Suppose an investor invests
$500 at the start of each year for 20 years and receives a 3% annual
return. See Case A in the next table. After 20 years the investment will
have increased to $13,838, for a total outlay (or $ Flow in the table) of
$10,000. Nice, but hardly exciting as the return was only low at 3% pa.
- But if the investor put the
same flow of money in an asset returning 7% a year, after 20 years it will
have grown to $21,933. See Case B. Not bad given the same total outlay of
$10,000. And in year 20, annual investment earnings are now $1435, more
than three and a half times the investment earnings in the same year in
Case A of $403.
- Finally, if the whole
process was kicked off by a $2000 investment at the start of the first
year, with $500 each year thereafter and still earning 7% per annum then
after 20 years it will have grown to $27,737. Case C. By year 20 in this
case the annual investment earnings will have increased to $1815.
These
examples have been kept relatively simple in order to illustrate how
compounding works. Obviously all sorts of complications can affect the final
outcome including inflation (which would boost the results as the table uses
relatively low returns for both the low and high risk asset), allowance for the
more frequent compounding which actually occurs in investment markets as
opposed to annual compounding in the table (which would also boost the final
outcome) and the timing of the return from the high growth asset through time
in that it won’t be a steady 7% year after year.
Source:
AMP Capital
However,
the power of compound interest is clear. From these examples, it is evident
that it has three key drivers:
- The rate of return – the higher the better.
- The contribution – the bigger the better because it
means there is more for returns to compound on. The $2000 upfront
contribution in Case C boosted the outcome after 20 years by an extra
$5804 compared to Case B. Not bad for just an extra $1500 investment.
- Time – the longer the better because it means the longer
the compounding process of earning returns on returns has to run. Time
will also help smooth out any year to year volatility in returns. After 40
years the investment strategy in Case A will have grown to $38,832 but
Case B will have grown to $106,805 and Case C will have grown to $129,267.
Compound interest in practice
This all
sounds fine in theory, but does it really work in practice? It’s well-known
that growth assets like shares and property provide higher returns than defensive
assets like cash and bonds over long periods of time. This is because their
growth potential results in higher returns over long periods of time which
compensates for their higher volatility compared to more stable and less risky
assets.
The next
chart is my favourite demonstration of the power of compound interest in action
for investors. It shows the value of $1
invested in 1900 in Australian cash, bonds and shares with earnings on each
asset reinvested along the way. Since 1900 cash has returned 4.8% per annum,
bonds have returned 6% pa and shares returned 11.9% pa.
Source:
Global Financial Data, AMP Capital
Shares are clearly more volatile
than cash and bonds. The
arrows in the chart show periodic, often long bear markets in shares. However,
the compounding effect of their higher returns over time results in much higher
wealth accumulation from them. Although the return from shares is only double
that of bonds, over 114 years the $1 invested in 1900 will have grown to
$398,420 today, whereas the $1
investment in bonds will only be worth $750 and that in cash just $204.
Now of
course, investors don’t (usually) have 114 years. But the next chart shows rolling 20 year returns from
Australian shares, bonds and cash and it’s evident that shares have invariably
outperformed cash and bonds over such a period.
Source:
Global Financial Data, AMP Capital
Note that
while the return gap between shares on the one hand and bonds and cash on the
other has narrowed over the last 20 years this reflects the relatively high
interest rates and bond yields of 20-30 years ago, which provided a springboard
to relatively high returns from such assets. With bond yields and interest
rates now very low such bond and cash returns are very unlikely to be repeated
in the decade or so ahead.
Some issues
What
about property? Over
long periods of time Australian residential property has generated similar
total returns (i.e. capital growth plus income) for Australian investors as
Australian equities. For example since 1926 Australian residential property has
returned 11.1% pa, which is similar to
the 11.5% pa return from shares over the same period.
What
about fees? Fees on
managed investment products will clearly reduce returns over time, but less so
for cash and fixed income products and for equities the fee impact will be offset by the impact of franking credits in the
case of Australian shares (which amount to around 1.3% pa) and which has not
been allowed for in the last two charts.
Are these
returns sustainable going forward? This is really a separate topic, but the historical
returns from the three assets likely all exaggerate their future medium term
return potential. Cash rates and bank term deposit rates are likely to hover
around 3-4%, current ten year bond yields around 3.4% suggest pretty low bond
returns for the decade ahead (in fact just 3.4% for an investor who buys a ten
year bond and holds it to maturity).
And the Australian equity return may be closer to 9% pa, reflecting a dividend
yield around 4.5% and capital growth of around 4.5%. But for shares this sort
of return is still not bad and leaves in place significant potential for
investors to reap rewards from the power of compounding over the long term.
Why investors often miss out
But if
the power of compound interest is so obvious, what can cause investors to miss
out. There are several reasons:
- First investors may be too conservative in their
investment strategy, opting for lower returning defensive assets like cash
or bank term deposits. This may avoid short term volatility but won’t
build wealth over the long term if that’s the objective.
- Second, they leave it too late to start contributing to an investment portfolio
or don’t contribute much initially. This makes it more difficult to catch
up in later life and leaves investors more at the whim of financial market
fluctuations during the catch up phase. Fortunately the Australian superannuation
system forces Australian’s to start
early in life, albeit the contribution rate is too low.
- Third, they can adopt the right strategy to benefit from
compound interest over the long term only to get thrown off during a bout
of market volatility. This usually occurs after a steep slump in
investment markets and sees the investor switch to cash only to return, if
at all, after the market has already had a good recovery.
- Finally, some investors have
been sucked in over the years by
promises of a “free lunch”, e.g. the 10% pa yield funds that were
floating around prior to the GFC which then ran into trouble once the GFC
hit and proved to be more risky than equities.
Implications for investors
There are
several implications for investors looking to take advantage of the power of
compound interest.
First, if you can take a long term approach, focus
on growth assets like shares and property with a long term track record.
Second, start contributing to your investment
portfolio as much as you can as early as possible.
Third,
find a way to manage cyclical swings. For example, invest a bit of time in understanding that the investment cycle is a
normal part of investment markets and partly explains why growth assets have a
higher return in the first place. Or invest in funds that undertake dynamic
asset allocation to help manage the investment cycle. Or both.
Finally,
if an investment sounds too good to be true – implying some sort of free lunch
– and/or you can’t understand it, then
stay away.
as noted this article from a fund manager needs to be revisited. remember when we were teaching maths it was a grade 10 topic. it is too important financially to not be reminded.
'if you wish to be better off in three years time what to you need to do today so that you are better off?
John McAuliffe
as others do call us on 07 3848 1088
or email us or visit our websites.
