If there’s one “technical thing” investors should know about investing, it’s the power of compound interest. In the rush to understand the short-term developments affecting the investment markets regarding the economy, interest rates, earnings, politics, etc., and in recent times the coronavirus is often overlooked. This can be a borrower’s worst nightmare as interest is charged on interest if it is not regularly maintained. But it is an investor’s best friend. Well-known Australian economist Dr Don Stammer calls it the âmagicâ of compound interest. I refer to it often, but given its importance, this note updates a note I wrote a few years ago looking at what it is, how it works, various issues surrounding it, and why investors often miss it.
What is compound interest?
Compound interest is simply the concept of earning interest on interest or earning a return on past performance. In other words, any interest or return earned in one period is added to the initial investment so that it all earns interest or a return in the following period. Etc. This is best demonstrated by a few examples.
â¢ Suppose an investor invests $ 500 at the start of each year and receives an annual return of 3% (see Case A in the following table). After 20 years, the investment will have increased to $ 13,838, for a total expenditure (or $ Flow) of $ 10,000.
â¢ But if the investor invests the same flow of money in, say, a higher risk asset that is earning on average 7% per annum, after 20 years it will have risen to $ 21,933 (case B). And in year 20, the annual income is now $ 1,435, well above the investment income for the same year in case A of $ 403.
â¢ Finally, if the process was started with an investment of $ 2,000 at the start of the first year, with $ 500 each year thereafter and still yielding 7% per year, then after 20 years it will have grown to 27,737 $ (case C). In the 20th year, in this case, the annual investment income will have increased to $ 1,815.
These examples are relatively simple, in order to show how the composition works. All kinds of complications can affect the end result, including inflation (which would increase nominal results as the chart uses relatively low nominal returns), a more frequent build-up that occurs in investment markets (which would also increase the nominal return. end result) and the timing of the average return of the high growth / riskier asset over time in that it will not be stable by 7% year over year.
Source: AMP Capital
However, the power of compound interest is clear. From these examples, it is evident that it has three key factors:
â¢ Rate of return – the higher the better.
â¢ Contribution – the bigger the better, because it means there is more to compose. The initial contribution of $ 2,000 in Case C increased the result after 20 years by $ 5,804 over Case B. Not bad for an additional investment of $ 1,500.
â¢ Time – the longer the better, as this means that the longer the process of compounding returns to returns has to take. Time also helps to mitigate any volatility in returns from year to year. After 40 years, the investment strategy in Case A will have reached $ 38,832, but Case B will have reached $ 106,805 and Case C will have reached $ 129,267.
The following chart illustrates how, after about 15 to 20 years, the value of the investment in the higher yielding cases begins to increase exponentially as returns add to returns. This is why compound interest is often referred to as “magic”.
Source: AMP Capital
Compound interest in the practice
Growth assets like stocks and real estate offer higher returns than defensive assets like cash and bonds over long periods of time. This is because their growth potential generates higher returns over long periods of time, thus offsetting their higher volatility. The following graphic is my favorite demonstration of the power of compound interest in action. It shows the value of $ 1 invested in 1900 in Australian cash, bonds and stocks, with earnings from each asset being reinvested along the way. Since 1900, cash has returned 4.8% per year, bonds have returned 5.8% per year and stocks 11.8% per year.
Source: Global financial data, AMP Capital
Stocks are more volatile than cash and bonds. However, the cumulative effect of their higher returns over time results in a much greater accumulation of wealth. Although the return on stocks is only double that of bonds, over 121 years the $ 1 invested in 1900 will have risen to $ 757,784 today, while the $ 1 investment in bonds will only be worth 959. $ and the cash one only $ 242. Of course, investors are not 121 years old. But the following chart shows the 20-year rolling returns of Australian stocks, bonds and cash and its obvious stocks have consistently outperformed cash and bonds over such a period.
Source: Bloomberg, AMP Capital
While the yield spread between stocks on the one hand and bonds and cash on the other has narrowed over the past 30 years, this reflects the high interest rates and bond yields of it. 20-30 years ago, which generated relatively high returns from these assets. With bond yields and interest rates now very low, it is highly unlikely that these yields will ever happen again for these assets.
And the property? Over long periods of time, Australian residential real estate has generated similar total returns (i.e. capital and income growth) to Australian equities. For example, since 1926 Australian residential real estate has returned 10.7% per annum, which is similar to the 11.3% per annum return on stocks.
What about the fees? Commissions on managed investment products will reduce returns over time, but less for cash and bond products and for equities the impact will be offset by postage credits in the case of Australian equities (which hover around 1.2% per year) and which were not allowed in the last two charts.
Are these returns sustainable? This is a separate question, but the historical returns of the four assets probably all exaggerate their potential for future returns over the medium term (say 10 years). Cash rates and bank term deposit rates are currently below 1% and could only average 1-3% in the medium term, current 10-year bond yields around 1.7% suggest yields bonds that are weak enough for the next decade (in effect, an investor who buys and holds a 10-year bond). And the yield on Australian stocks could be closer to 8% per annum, reflecting a grossed-up dividend yield for postage credits of around 5% and capital growth of around 3%. But for stocks, that sort of return isn’t bad and still leaves significant potential for investors to reap the rewards of the power of long-term capitalization.
But why do investors often miss it?
But what can make investors lose the power of compound interest if it’s so obvious? There are several reasons:
â¢ Early investors may be too conservative in their investment strategy, opting for low yielding defensive assets such as cash or bank deposits. It can avoid short-term volatility, but will not create long-term wealth.
â¢ Second, they leave it too late to start investing or don’t contribute much to start. This makes it difficult to catch up later in life and leaves them more at the mercy of fluctuations in the financial markets. Fortunately, the retirement pension system is forcing Australians to start early in life, although early withdrawals linked to last year’s pandemic may have disrupted that for some.
â¢ Third, they attempt to “beat” the market either by trying to time the market movements up or down, or by buying and selling particular stocks. Getting it right is easier said than done, and investors often end up doing it wrong – buying on the top and selling on the bottom, which destroys wealth.
â¢ Fourth, they are not diversified enough.
â¢ Finally, some are drawn over the years into investment opportunities that seem to promise a free lunch, which then fail. The key is to verify that the asset produces fundamental value and is not just dependent on the crowd pushing it higher.
Implications for investors
There are several implications for investors looking to harness the power of compound interest.
First, if you can take a long-term approach, focus on growth assets like stocks and real estate with a long-term track record.
Second, start contributing as much to your investment portfolio as possible as early as possible.
Third, find a way to deal with cyclical fluctuations. For example, invest some time to understand 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.
Finally, if an investment sounds too good to be true – involving a free lunch – or if you can’t figure it out, then steer clear.