The Power of Compounding

Wednesday, March 20, 2019

In these volatile markets it’s worthwhile to remember the power of compound interest. Long term returns on investments are affected by compound interest. It may seem a bit like magic but it’s actually pure math.

The markets finished 2018 at a low point due to a range of global influences such as the China/US threatened Trade War, Trumponics, uncertainty over the Banking Royal Commission, pending Australian elections, and Brexit issues. The markets then recovered in January and it has been interesting to see how quickly the markets have returned once certainty has appeared as a result of the release of the Banking Royal Commission report. The report wasn't necessarily good news, but it just wasn't as harsh as the pessimistic share market had factored into banking share prices. This led to banking stocks jumping by at least 5% in 1 days trading.  

Long term returns on investments are affected by compound interest. It may seem a bit like magic but it’s actually pure math. Unfortunately many miss out on its gifts because they are too busy looking for disasters around the corner or assuming that once disaster hits it will be with us long term. When we compare the value of $1 invested in various Australian assets (Cash, Bonds, Shares)  in 1900, allowing for the reinvestment of dividends and interest along the way, that $1 would have grown to $238 if invested in cash, $906 if invested in bonds, OR $532,739 if invested in shares. While the average return on shares is only double relative to bonds since 1900, the huge difference between the two at the end owes to the power of compounding or earning returns on top of returns i.e. any interest or return earned in one period is added to the original investment so that it all earns a return in the next period……. and so on. Australian residential property data over the decades reveals, on average, similar long term compounded returns to shares.

The “Law of 72” is helpful to understand how long it takes an investment to double in value using compounding. Just divide 72 by the rate of return and that gives you the rough answer.  For example, if the rate of return is 2% per annum (eg, the interest rate on a bank term deposit), it will take approx. 36 years to double in value (72/2=36). But if it’s 8% pa, then it will take just 9 years (72/8 = 9).

To grow our wealth, this would reveal it is better to have broad exposure to growth assets like shares and property. While shares have been volatile lately and the short-term outlook for Australian housing is messy, both will likely do well over the long term.

In the short term, investment markets bounce all over the place. Even annual returns in the share market are highly volatile, but longer-term returns tend to be solid and relatively smooth. Since 1900, for Australian shares about two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods. (It’s roughly three years out of ten for US shares since 1900.)

As always, consult your Financial Adviser on how to best invest your money in these current markets. 

This document was prepared without taking into account any person’s particular objectives, financial situation or needs. It is not guaranteed as accurate or complete and should not be relied upon as such.  Maher Digby Securities does not accept any responsibility for the opinions, comments, forward looking statements, and analysis contained in this document, all of which are intended to be of a general nature. Investors should, before acting on this information, consider the appropriateness of this information having regard to their personal objectives, financial situation or needs. We recommend consulting a financial advisor