Note: This article was originally published on Oliver’s Insights on 16 July 2014 and has been republished with permission from the original author.
I reckon the first wonder of the investment world is the power of compound interest. My good friend Dr Don Stammer even goes so far to refer to it as the “magic” of compound interest because it almost is magical. Compound interest can be the worst nightmare of a borrower as interest gets charged on interest if it is not regularly serviced. But it’s the best friend of investors. Unfortunately for a variety of reasons some miss out on it.
Compound interest – what is it?
But what is it and why is it so powerful? Compound interest is simply the concept of earning interest on interest. Or more broadly, getting a return on past returns. In other words any interest or return earned in one period is added to the original investment so that it all earns interest or a return in the next period. And so on. Its best demonstrated by some examples.
These examples have been kept relatively simple in order to illustrate how compounding works. Obviously all sorts of complications can affect the final outcome including inflation (which would boost the results as the table uses relatively low returns for both the low and high risk asset), allowance for the more frequent compounding which actually occurs in investment markets as opposed to annual compounding in the table (which would also boost the final outcome) and the timing of the return from the high growth asset through time in that it won’t be a steady 7% year after year.
Source: AMP Capital
However, the power of compound interest is clear. From these examples, it is evident that it has three key drivers:
Compound interest in practice
This all sounds fine in theory, but does it really work in practice? It’s well-known that growth assets like shares and property provide higher returns than defensive assets like cash and bonds over long periods of time. This is because their growth potential results in higher returns over long periods of time which compensates for their higher volatility compared to more stable and less risky assets.
The next chart is my favourite demonstration of the power of compound interest in action for investors. It shows the value of $1 invested in 1900 in Australian cash, bonds and shares with earnings on each asset reinvested along the way. Since 1900 cash has returned 4.8% per annum, bonds have returned 6% pa and shares returned 11.9% pa.
Source: Global Financial Data, AMP Capital
Shares are clearly more volatile than cash and bonds. The arrows in the chart show periodic, often long bear markets in shares. However, the compounding effect of their higher returns over time results in much higher wealth accumulation from them. Although the return from shares is only double that of bonds, over 114 years the $1 invested in 1900 will have grown to $398,420 today, whereas the $1 investment in bonds will only be worth $750 and that in cash just $204.
Now of course, investors don’t (usually) have 114 years. But the next chart shows rolling 20 year returns from Australian shares, bonds and cash and it’s evident that shares have invariably outperformed cash and bonds over such a period.
Source: Global Financial Data, AMP Capital
Note that while the return gap between shares on the one hand and bonds and cash on the other has narrowed over the last 20 years this reflects the relatively high interest rates and bond yields of 20-30 years ago, which provided a springboard to relatively high returns from such assets. With bond yields and interest rates now very low such bond and cash returns are very unlikely to be repeated in the decade or so ahead.
What about property? Over long periods of time Australian residential property has generated similar total returns (ie capital growth plus income) for Australian investors as Australian equities. For example since 1926 Australian residential property has returned 11.1% pa, which is similar to the 11.5% pa return from shares over the same period.
What about fees? Fees on managed investment products will clearly reduce returns over time, but less so for cash and fixed income products and for equities the fee impact will be offset by the impact of franking credits in the case of Australian shares (which amount to around 1.3% pa) and which has not been allowed for in the last two charts.
Are these returns sustainable going forward? This is really a separate topic, but the historical returns from the three assets likely all exaggerate their future medium term return potential. Cash rates and bank term deposit rates are likely to hover around 3-4%, current ten year bond yields around 3.4% suggest pretty low bond returns for the decade ahead (in fact just 3.4% for an investor who buys a ten year bond and holds it to maturity). And the Australian equity return may be closer to 9% pa, reflecting a dividend yield around 4.5% and capital growth of around 4.5%. But for shares this sort of return is still not bad and leaves in place significant potential for investors to reap rewards from the power of compounding over the long term.
Why investors often miss out
But if the power of compound interest is so obvious, what can cause investors to miss out. There are several reasons:
Implications for investors
There are several implications for investors looking to take advantage of the power of compound interest.
First, if you can take a long term approach, focus on growth assets like shares and property with a long term track record.
Second, start contributing to your investment portfolio as much as you can as early as possible.
Third, find a way to manage cyclical swings. For example, invest a bit of time in understanding 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. Or invest in funds that undertake dynamic asset allocation to help manage the investment cycle. Or both.
Finally, if an investment sounds too good to be true – implying some sort of free lunch – and/or you can’t understand it, then stay away.