If there is one “technical thing” investors should know about investing, it’s the power of compound interest. In the rush to understand short-term developments impacting investment markets regarding the economy, interest rates, profits, politics, etc, and in recent times coronavirus its often forgotten about. It can be the worst nightmare of borrowers as interest gets charged on interest if it’s not regularly serviced. But it’s the best friend of investors. The well-known Australian economist Dr Don Stammer refers to it as the “magic” of compound interest. I often refer to it, but given its importance, this note updates one I wrote a few years ago looking at what it is, how it works, various issues around it and why investors often miss out.
Compound interest is simply the concept of earning interest on interest or 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 are relatively simple, in order to show how compounding works. All sorts of complications can affect the final outcome including inflation (which would boost the nominal results as the table uses relatively low nominal returns), more frequent compounding which occurs in investment markets (which would also boost the final outcome) and the timing of the average return from the high growth/more risky asset through time in that it won’t be a steady 7% year after year.
However, the power of compound interest is clear. From these examples, it is evident that it has three key drivers:
The next chart illustrates how after about 15 to 20 years the value of the investment in the higher returning cases starts to rise exponentially as returns build on top of returns. This is why compound interest is often described as “magical”.
Growth assets like shares and property provide higher returns than defensive assets like cash and bonds over long periods. This is because their growth potential drives higher returns over long periods of time compensating for their higher volatility. The next chart is my favourite demonstration of the power of compound interest in action. 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% pa, bonds returned 5.8% pa & shares 11.8% pa.
Shares are more volatile than cash and bonds. 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 121 years the $1 invested in 1900 will have grown to $757,784 today, whereas the $1 investment in bonds will only be worth $959 and that in cash just $242. Of course, investors don’t have 121 years. But the next chart shows rolling 20 year returns from Australian shares, bonds and cash and its evident shares have invariably outperformed cash and bonds over such a period.
While the return gap between shares on the one hand and bonds and cash on the other narrowed over the last 30 years this reflects the high interest rates and bond yields of 20-30 years ago, which drove relatively high returns from these assets. With bond yields and interest rates now very low such returns are very unlikely to be repeated from these assets.
What about property? Over long periods of time Australian residential property has generated similar total returns (ie capital growth plus income) as Australian equities. For example, since 1926 Australian residential property has returned 10.7% pa, which is similar to the 11.3% pa return from shares.
What about fees? Fees on managed investment products will reduce returns over time, but less so for cash and fixed income products and for equities, the impact will be offset by franking credits in the case of Australian shares (which are around 1.2% pa) and which have not been allowed for in the last two charts.
Are these returns sustainable? This is a separate issue, but the historical returns from the four assets likely all exaggerate their future medium-term (say 10 years) return potential. Cash rates and bank term deposit rates are currently below 1% and may only average 1 to 3% over the medium term, current 10-year bond yields of around 1.7% suggest pretty low bond returns for the decade ahead (in fact just 1.7% for an investor who buys and holds a 10-year bond). And the Australian equity return may be closer to 8% pa, reflecting a grossed up for franking credits dividend yield around 5% and capital growth around 3%. But for shares, this sort of return is not bad and still leaves in place the significant potential for investors to reap rewards from the power of compounding over the long term.
But what can cause investors to miss out on the power of compound interest if it’s so obvious? There are several reasons:
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.
Finally, if an investment sounds too good to be true – implying a free lunch – or you can’t understand it, then stay away.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.