Albert Einstein supposedly once said that the most powerful force in the universe is compound interest. Naturally, investors seek compound growth, but they often fail to capture its full benefit.
The principle of compound growth can be defined as the power of exponential growth, that is, growth on growth. It’s like a snowball effect whereby you receive growth, not only on your original investments, but also on any interest, dividends, and capital gains that have accumulated — thus, your money can grow faster and faster as time goes on.
Recently we released a white paper called “Math Matters: Rethinking Investment Returns & How Math Impacts Results.” The choice of a title was deliberate: math really does matter to the ultimate success or failure of an investment plan.
However, the irrefutable truths of these mathematical principles sometimes get lost when fear and greed take over the investor’s mind. The white paper seeks to fortify rational investors by proving the importance of four mathematical concepts, namely:
The importance and power of compound growth
The importance of avoiding large losses to returns
The importance of variance drain/volatility drag
The value of a non-normal distribution of returns
In future blog posts, we will discuss the latter three points, but this post is focused on the power of compounding returns.
While it sounds simple, the concept of compound growth and its impact can be a difficult one to grasp.
Why is compound growth so important and how does it impact the returns one might achieve with an investment?
One of the best ways to illustrate the power of compound growth is through a simple hypothetical illustration.
There are two major takeaways from this illustration. The first being:
- It takes a while for the power of compounding to really take effect.
After 20 years, an initial investment of $100,000 that grows at a 12% annual rate is worth $964,629; a gain of $864,629. Not bad at all. However, over the following 20 years that $964,629 grows to $9,305,097, an increase of $8,340,468 (highlighted in the table below). That is the power of compounding returns.
The separation in the lines of the chart above, and the difference between the numbers in the table below, is not significant until years into the investment timeline. That means investors need to remain invested to allow for the time that compound growth needs to work its magic.
Viewed another way, the difference between a 10% annual rate of return and a 12% annual rate of return on an initial investment of $100,000 is only $291,879 after 20 years: $672,750 vs $964,629, respectively.
However, after 40 years the difference is immense. Those extra 200 basis points will more than double the value of an investment: $4,525,926 at 10%, $9,305,097 at 12%.
Of course, this is a theoretical example meant to illustrate a mathematical point. In the real world, it’s safe to say no one has ever seen an investment that has provided a constant 10%, 12%, or 15% annual return over 40 years with zero volatility, or fluctuation, in value over a given period.
This highlights the second major take-away from this illustration:
- Volatility or losses will have a big impact on the ending wealth of any scenario.
The hypothetical case above represents an ideal scenario: positive returns with no risk, no volatility, and no losses. In the real world, anything that causes a “reset” to the value of an investment will be detrimental.
In conclusion, yes, compound returns are a wonderful thing. However, the compounding power will be severely undermined by large losses and volatility. The extent to which large losses and volatility can limit or even overwhelm the power of compounding returns will be explored in future blog posts in this series.
Learn more about Swan’s DRS investment approach is designed to help investors remain invested and reduce volatility.