Compound interest – 8th wonder of the world?

Albert Einstein once famously said that compound interest is the 8th founder of the wonder and that “he who understands it, earns it; he who doesn’t, pays it.” 

There is no doubt that compounded returns are one of the fundamentals of wealth generation.

It is the means by which somebody on a middle-income can get rich slowly.

Building up a million, or multi-million investment portfolio, isn’t as hard as you may think as the charts below show, although how much you invest is as important as time:

Source; Business Insider

However, there are two main problems with compounded interest. Firstly, you can’t realistically make compounded returns in the bank.

Most banks pay under the rate of inflation, unlike in Einstein’s days, so you are guaranteed to lose to inflation.

Secondly, compounded investment returns are very different to compounded interest which is stable every single year.

With compounded interest, you can work out returns very precisely.

$100,000 generating 5% per year for 10 years, in the bank, results in very precise returns.

In investing though, your returns won’t be constant. Even though the S&P500 has produced 10% per year on average, adjusted for reinvesting dividends, that is a broad average.

It produced about 10.2% per year from 1960 until 1990, but was stagnant from 1965 until 1982.

More recently it was stagnant from 2000-2009, but had an excellent run from 2009-2018.

The point being, we can’t predict when markets will outperform their long-term average, or underperform.

The chart below further illustrates that point – most decades are either significantly better or worse than the 10% yearly average.

The returns of the markets aren’t predictable

What then can investors do?

The best thing an investor can do is see themselves as a collector. When investors are young, or even 40 or 50 years olds, they are net buyers of units and investments more generally.

When we are retired or even within 5 years of retirement, we are net sellers, assuming that we need to sell off part of our portfolio to fund retirement.

So what does that mean for our returns? It means that stagnating markets will benefit our long-term return expectations.

Let’s give a simple example

Steve has inherited $100,000 and invests $1,000 a month for 40 years.

He gets a stable 6% return every single year for 40 years. Almost impossible I know but let’s keep to the example.

David also invests the exact same amount – 100k and 1k a month for 40 years.

However, his account produces 0% for the first 10 years, then 10% for the next 20 years and then 5% for the final 10 years.

Gina also invests the same amount. Her account produces 0% for the first 17 years ( like the period from 1965-1982) 8% for the next 13 years and then 17% for the final ten years (similar to the bull market of the 1990s).

What are the results?

Steve would have 2.9m – minus inflation of course. David would have 3.8m.

Gina would have 5.6m! So Gina would have almost double as much as Steve, who got the constant compounded returns.

The reason is simple. Gina got the higher returns during a period where her account was worth more in the later years.

The 0% returns for the first 17 years were gained at a time when her accounts were worth less.

What does this mean?

Investors should focus on leveraging time. The longer you invest means the lower the risks and the higher the chances of excellent returns.

However, people shouldn’t be afraid of falling or stagnating markets, or indeed volatility.

Constant returns might feel emotionally more satisfying, but that doesn’t make it the best option in all cases.

As per the results above, it is more profitable in the long-term if markets are down and you keep investing.

That doesn’t mean you should time the markets, merely that you should welcome any falls.

Further Reading

How much do you need to invest to get rich investing?

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