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.
