The Reality of Compound Returns

Albert Einstein was reportedly quoted as stating that compound interest is the most powerful force in the universe. However, compound interest is also one of the most misunderstood, misrepresented and most destructive forces as well…even in the professional realm.

As the euphoria of “DOW 13,000!!!” takes hold of the investment world, the talking heads are, once again, bantering about whether it is safe to invest again. As I wrote in this blog just over a year ago, that is absolutely the wrong question to ask. Ultimately, your behavior and ability to stick to an investment philosophy will have a far greater impact on your investment success than the actual strategy or investments themselves.

Ultimately, successful investing depends on your ability to participate in the “miracle of compounding”. You can scour the internet for days and find endless examples such as the following:

Tom and Mary are saving for retirement.

1. Tom begins saving $5,000 per year at age 25 and continues to do for 10 years. At age 35, Tom stops and never saves a penny again.

2. Mary waits until age 35 to begin saving, but then saves $5,000 per year until she reaches age 65.

Assuming they each earn 8% per year, here is how the scenario breaks down:

The critical take-away is to start early because the longer you allow your money to compound, the more significant the impact it will have.

Now, here’s the cold, hard reality about compound returns:

Negative returns have a far greater impact on investment performance than positive returns

Consider the following scenarios:

On the surface, based on the average annual return, it appears that both portfolios end up in the same place, despite taking very different roads to get there. However, the end result is astonishingly different.

If Portfolio A starts with $100 and earns a 10% return, you end up with $110. If you then lose 10% the next year, you actually lose $11 (not $10), leaving you with $99. When you apply the same math to Portfolio B, your end result will be $75.

Circling back to the assumption of 8% returns from Tom and Mary above, if Tom earned 20% in year one, followed by -12% in year two, the average of those two returns is 8%, but the actual return experienced by Tom plummets to 5.6%.

And just to drive things home further, assume Tom earns 50% in year one and -34% in year two. The two year simple average is +8%, but the actual return is -1%. It is possible to have a positive average return, but negative results.

So what does this look like in the real world?

I recently came across a video produced by a large investment advisory company that provided a classic example that even professional investors misunderstand how compounding actually works.

In this case, the fund manager only produced “alpha” for his clients in 9 of the 18 years since he launched his fund. In other words, he beat the index only half of the time. Further, if one were to calculate the average alpha produced during those 18 years, it would be negative. Therefore, the folks in the video concluded he actually produced negative alpha for his clients over that period.

In reality, people who actually invested in this fund for that period would have made 50% more money (or 50% more alpha) than if they had invested in the index. The exercise of comparing year-to-year performance against an index is extremely counter-productive.

To restate these facts again, the fund only beat its benchmark 50% of years, yet produced a total return 50% greater. The explanation of this paradox is quite simple. This fund avoided large losses. It outperformed the benchmark when it was down, and underperformed when it was up.

None of this is meant as an indictment of folks who index or the indexing philosophy. In fact, due to investors pouring out of the fund while it was lagging in the tech boom (and just before the 2000 – 2002 crash), index investors likely fared better than this fund’s investors…an indictment of poor investor behavior.

When investors like Warren Buffett explain that rule #1 in investing is to not lose money (and rule #2 is to never forget rule #1), this is one of the concepts they have in mind. They do not mean that your portfolio should never decline in value, but jumping out of an underperforming fund (or stock, or index) into something else at the wrong time will land you on the wrong side of the compound interest formula.

The US stock market continues to be one of the greatest wealth building machines ever created, but the extent of your participation is entirely dependent on which side of the compounding equation you fall.