In episode 15 on the Wilson Wealth Management YouTube channel, we examine compound returns and its significant impact on wealth accumulation and investing success over time.
We indirectly looked at this concept in episode 14 on time horizons. How your available time to reach a financial objective will impact your funding requirements and the level of investment risk that must be assumed.
The time you allow your money to grow is crucial to wealth accumulation. In fact, over longer time periods, it is the income earned on previous income earned that is the bulk of your wealth growth. Not what you actually contributed to the investment account. Perhaps hard to believe. But, as we shall see, quite true.
Understanding the “power of compounding” is crucial for investors. In this episode, we look at:
What is simple return?
What is compound return? How does it differ from simple returns? Using an example from the world of Harry Potter.
What are the keys to maximizing your use of compounding in your own portfolios?
What are the three interrelated variables in compound growth? We drill a little deeper into how time horizon, risk, and funding impact each other.
What are the two biggest drags on your ability to build your wealth?
We finish our analysis with comparison of the Ant and the Grasshopper. Sadly, not the Aesop’s Fable. Instead, a real world example of compound returns in action.
Hopefully, you will see the value in beginning your investing program early in life. Utilizing tax-free and tax-deferred investment accounts. And working to minimize your investment costs. So that your capital can compound your benefit, not grow in accounts of your bank, advisor, or government.
Unless you are counting on that big inheritance or playing the lottery every week, your best shot is through investing.
Keys to Compound Return Benefits
The key is to start when you are young. The amount that you invest is somewhat less important than the time frame. If you are not young, start now. You can still benefit from compounding, though to a lesser extent.
Prudently invest on a consistent basis and let the power of compounding do its thing. We will examine what might constitute “prudent” investing in due course.
Utilize tax-free or tax-deferred investment accounts to enhance compounding impact. Look to low-cost investment products to reduce fees and expenses. You want your money to compound on your behalf. Not to enrich the government, investment company, or your friendly financial advisor.
Please consider the story of Nicole and Matt. Not quite an Aesop Fable, but good moral lessons contained within.
The Ant
Nicole is turning 25 years old, has just started a new job, and wants to begin saving for her retirement. She decides to save $300 per month in a tax-deferred retirement account.
Based on historic returns, she expects to earn a net 8% per year in a family of no-load diversified mutual funds that reinvest any income earned back into the funds. We will assume that income compounds semi-annually.
Following this strategy, by age 40, Nicole will have invested $54,000 in total. However her asset value will be worth $104,504 due to the 8% net annual return and compound growth.
If Nicole is wise, she will increase her monthly contributions over time as her salary increases. She will also continue investing until the day she retires.
But at age 40, Nicole decides to set up a separate investment account with her husband and no longer contributes to her first plan. Nicole does not liquidate her initial retirement plan so that $104,504 will continue to grow at 8%.
At age 70, Nicole terminates her individual plan. She is surprised to discover her asset balance has grown to $1.09 million.
For a relatively brief commitment of 15 years and $54,000, she became a millionaire. Not too bad.
And the Grasshopper
Matt is Nicole’s twin brother. Matt has a well-paying job but he always seems to spend as much as he earns. At month end there is nothing left to save, although he does have a nice tan from his recent vacation to Hawaii.
As he turns 40, he notices that Nicole has done quite well from her monthly saving plan. Wanting to copy her success, Matt visits a financial planner.
Matt knows that Nicole has stopped saving. With 30 years to invest, twice the time frame as Nicole had, Matt figures that it will be simple to catch up with her. Maybe he can even do so with less than $300 per month. That would be great.
Matt instructs the financial planner to create an identical investment strategy as Nicole. That is, the same diversified portfolio of low-cost mutual funds netting an 8% annual return with income semi-annually compounding.
Unfortunately, Matt does not understand the concept of compound returns. So he receives quite the shock when he gets the financial planner’s program.
To catch Nicole at 70, Matt must invest $750 monthly for 30 years in an account earning 8%, compounded semi-annually.
Nicole invested $54,000 over a 15 year period.
To match her accumulated $1.09 million in wealth, Matt must contribute $270,000 of his own money over 30 years.
Matt must find more than double the cash that Nicole invested each month and he must do so for twice the time frame. In total, Matt must pull five times the cash out of his own pocket to achieve the same result as his sister.
A lot more sacrifice for Matt to amass the same wealth as Nicole. Smart lady.
Moral of the Story
That is the power of compounding.
Start investing as young as you can. The longer the time frame the better.
The sooner you begin, the less you actually need to invest in total contributions.
Even relatively small investments can grow to large amounts over a long time period.
Return is crucial. Gross returns on the investment itself. But equally so the net returns after fees, costs, and taxes.
Had Matt been able to net 9% annually, rather than 8%, he could achieve almost the same total investing only $600 monthly. If his return was only 7%, he would need to make monthly contributions of $900.
At the 8% return, Matt’s monthly contribution of $750 for 30 years grew to $1.096 million. Now let us say that the mutual fund company he chooses charges a 1.0% annual management fee on the funds. Not a lot as far as most charge. And really, what is 1.0% among friends?
However, that reduces his net return to 7% and his assets only grow to $902,000. A decrease of $194,000 in wealth.
A percentage of return paid to a fund company, bank, or advisor annually, has enormous long term ramifications your wealth. Finance your own retirement, not someone else’s.
We compared the investment return concept of simple versus compound in Compound Returns. We saw how compounding may actually result greater asset growth than that from an investment alone.
Today we examine some very important investing lessons resulting from the power of compounding. If you understand and adhere to these lessons, you will improve your investing results and wealth accumulation.
For all the lessons below, we shall use the same basic data from the following example:
You invest $1000 in a bond fund earning a 10% rate of return, compounded annually. Earned interest is automatically reinvested in additional fund units. Changing interest rates, capital gains or losses, taxes, and transaction costs are ignored. After 10 years your investment will be worth $2594 ($1000 initial investment, $1000 interest on your capital; $594 interest on compounded reinvested income).
Assuming all other variables remain unchanged, here are the key investment lessons:
The longer the investment period, the greater the impact of compounding.
Time is a crucial component for compounding.
In our example, after 10 years your initial investment grew to $2594. Not bad. But if you leave that money alone for 50 years, your one time investment of $1000 grows to $117,391. Impressive.
Over that 50 years, you only earned $5000 (50 years X $100 per year interest) in simple return. The rest of the increase is due to compounding. That is, interest earned on interest.
The farther out the year, the greater its impact of compounding.
After 10 years at 10%, you end up with $2594.
If you need the cash after year 9, you only get $2358. Not that bad, but you lose more than just the $100 simple return in year 10. You also lose an extra $136 in interest due to lost compounding. Not great, but not too bad.
However, if you need the money in year 49, you only receive $106,719 versus the $117,391 if you held out until year 50. That lost $10,672 is huge. And almost all of it reflects the compound interest effect over the years.
The longer you can keep money compounding, the greater the incremental impact. Think of that before accessing your tax-free or tax-deferred investment plans.
The higher the rate of return, the greater the impact of compounding.
All else equal, the rate of return has a big influence on performance.
At a 10% compound return, a single $1000 investment grows to $2594 in 10 years and to $117,391 in 50 years.
Had you found an extra percent return, the impact is noticeable. Over 10 years, you end up at $2839, an improvement of 9.5%. Over 50 years, you get $184,565, a change of 57%.
A big concern with investment product fees that reduce net returns. If you own a mutual fund that charges 1.5% annually, that 10% return nets to 8.5%. Your bond fund now will be worth only $2261 in 10 years and $59,086 in 50 years.
Over 10 years that “fee” to the fund company reduces your wealth $333. Over 50 years, $58,305. And that is all based on you investing a mere $1000. Think of the wealth accumulation differential if you invest a $100,000 or more.
That is a lot of money you are giving away to the mutual fund company in exchange, I expect, for “free advice.” Let your wealth compound in your account, not in the fund company’s coffers.
The more periods in a year an investment compounds, the greater the impact of compounding.
The greater the periods, the more times interest will be calculated, the sooner the next round of compounding can begin.
May sound odd, but think of a home mortgage. The more payments made in a year, the quicker the principal falls. Even if the aggregate value of payments in a year is equal.
In our first example, interest was compounded on an annual basis. That gave us the end values of $2594 over 10 years and $117,391 over 50 years.
Compounding monthly, our investment grows to $2707 in 10 years and $145,369 in 50 years.
And daily compounding results in asset values of $2718 in 10 years and $148,312 in 50 years.
Exactly the same investment with the same time frame. Yet just by accelerating the compound periods you are able to increase your overall return.
The less your costs, the greater the impact of compounding.
Costs such as taxes, sales commissions, management fees, and transaction costs, all reduce your monetary return. Less return translates into less money being reinvested. That significantly affects the power of compounding over time. Be very aware of this.
We saw the impact of fund fees above. Taxes are another huge area to try and minimize and/or defer.
Without being too detailed, let’s assume you pay a reasonable 30% tax rate on your earned income. So for each $100 in interest you earn, only $70 can be reinvested. In essence, your annual return has fallen to 7% from 10%.
In our example, your $1000 would only grow over the 10 years to $1967 and not $2594. The government took $300 in taxes, but you also lost $327 in compound interest.
Annoyed? If so, stop reading.
Over 50 years, you only finish with $29,457 and not the $117,391 before tax.
Take advantage of available tax-free and tax-deferred investment accounts.
The same holds true for other costs, such as management fees and transaction costs. Money paid to others will not accumulate on your behalf. 1% fees here or there may seem like nothing. But as we saw above, they can be massive over time.
We will look at ways to minimize costs at a later date.
Conclusion
The younger you begin to invest, the longer the time horizon until retirement. This is great for compounding returns.
Being younger also allows you to take on higher levels of risk in an attempt to earn better returns. Again, something very useful for compounding growth.
The later in life you begin to invest, the more at a disadvantage you will be. But the longest journeys begin with a single step. You just may need to allocate more to your portfolio to offset the lesser compound returns.
Additionally, as you can see from the lessons, minimizing your investment costs is crucial to long term growth. We will look at cost minimization strategies as we go along. But the keys are to avail of tax-free or tax-deferred savings plans and to minimize investment expenses paid to your advisors, fund managers, banks, etc.
Always let your wealth compound on your behalf. Not someone else’s.
I hope this clarifies the concept of compound interest and that you begin to take advantage of it.
Next up, realistic examples on how these compounding lessons impact wealth accumulation.
Before getting into mutual fund concerns, I want to cover a crucial investment concept. One that will help clarify a few of the problems with many investment funds. Namely, the concept of compound returns.
Understanding and properly utilizing the power of compound returns will likely grow your investment portfolio more than any individual investment selection.
Got your attention? Good. Because first we need to look at some calculations to understand compound return.
For the examples below, we will keep it straightforward. We shall assume this is a typical economist’s world with no taxes, no transaction costs, reinvestments at the prevailing rates, etc.
Simple Returns
Most are familiar with simple return. That is the return you receive from an investment in interest, dividends, or capital.
The important thing with simple return is that the money earned on the investment is not re-invested. You receive the interest or dividend and then you promptly spend it celebrating your shrewd investment skills.
For example, you purchase a $1000 bond at face value with a 10% interest rate paid annually. Each year you receive $100 in interest for a simple return of 10% annually. At the end of the 10 years, the bond matures and you are paid back your original $1000. The net return was also $1000 over the 10 years (10 payments of $100 per year).
You might also consider returns in your own life. Anywhere you work involves a return on your efforts.
Let’s say you work in a factory. You are paid for each box assembled and each day you can assemble 20 boxes. You pile them in the corner and your boss counts them Friday evening. Then you are paid $100 per box. Work harder and you might get 25 completed. Take it easy and you get less done. Friday night you should have 100 boxes completed and get paid $1000. The 100 boxes and the $1000 are the simple return for your labour.
Compound Returns
Compound returns are like simple returns, except you do not spend the money you receive from the investment. Instead, you reinvest the receipts at the same rate of return as the original investment.
Say you purchase a bond fund that will yield 10% annually for your $1000. Essentially the same investment as in our example above. However, interest earned on the fund is automatically reinvested in the fund so that your returns compound annually.
At the end of year one, you earn $100. Same as with the simple return. But instead of getting a cheque for $100 and spending it, the interest is automatically reinvested in additional fund units.
So that $100 of earned interest stays and will start to earn interest itself for the remaining 9 years of the investment. And that is the key to the power of compounding.
At the end of year two, your original $1000 will have earned another $100. Plus your year one interest of $100 will have returned an additional $10. This pattern continues over the life of the investment.
Each penny you earn on your investment will itself begin to generate its own future returns. And that future return will also start earning a return.
Now $10 here and there may not seem like much, but over time it really adds up. In fact, in many investment scenarios, the incremental returns from reinvesting previous returns is greater than the simple return.
In this example, at the end of 10 years your investment has earned you $1594. Compare this with the $1000 under the simple return. You did significantly better under the compound return.
Through the compounding in this example, you generated an extra 59% return over the 10 years. Not too bad for something that had no cost to you.
If it been a 20 year bond rather than 10, your cumulative simple return would be $2000. However, the total compound return would be $5727. The return from reinvesting the interest income is greater than the interest on your initial capital.
If we look at the warehouse job again, think of it as a factory from a magical world. On day one, you assemble your 20 boxes. On day two, you assemble another 20, but you notice the boxes from day one have risen up and started assembling more boxes themselves. By day’s end your pile has 20 boxes in it, but the boxes have contributed another 3, for a total of 23. A greater result, yet you did not work any harder.
On day three, you keep working on your 20 boxes. Again, those other boxes are assisting. As there are now 43 boxes to start day three, they generate 6.5 boxes rather than the prior day’s 3.
When your boss does the Friday count you are surprised to find 135 boxes assembled. You only assembled 100, but you ended up with a lot extra. And, as the boxes do not get paid, you get the entire $1350 for yourself.
You head home to enjoy the weekend, realizing that come Monday, the boxes will start producing more boxes each day than you do yourself. In time you can let them do all the work and assist your boss in finding a bigger warehouse for all the assembled boxes.
That is the power of compounding!
Next up, we shall look at Compound Return Investment Lessons.