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The Power of Compounding

 

CompoundingThey say that 'compounding' is the eighth wonder of the world, and not without good reason. Despite the difficult decade in global stock markets from 2000-2009, over the past 100 years returns from the global stock markets have averaged 8-9% per annum including dividend income. On the assumption that returns going forward will mirror the longer-term past, let us take a look at the following mind teaser which works well to demonstrate the power of compounding.

In the accompanying table on the right, Investor A starts to save for retirement at age 25 and puts €2,000 into his investment programme each year until he is aged 34. That's ten years and an investment of €20,000 in total. He does not contribute anything further to his investment programme after age 34 but he continues to generate a return of 8% each year on his investment until he retires at age 65.

The Power of CompoundingNow compare Investor A with Investor B who starts his investment plan later at the age of 35, just when Investor A is finished contributing to his plan. However, Investor B contributes €2,000 into his investment programme every year until he is aged 65 and gets the same return of 8% per annum. Over a period of 31 years, Investor B has put a total of €62,000 into his investment plan compared to only €20,000 for Investor A.

Now ask yourself - who has the largest lump sum saved at age 65? Surprisingly, even though Investor B has contributed €62,000 to his programme compared to only €20,000 by Investor A, it is Investor A who walks away with the bigger lump-sum.

The following analysis explains why; by the time Investor A has stopped contributing to his investment programme at age 34, he has already compounded his monies to €26,798. An 8% return on this lump-sum in the following year is €2,144 and already above the €2,000 that Investor B has just started to contribute to his investment programme. Investor B simply cannot catch Investor A in the time given.

Of the €26,798 that Investor A had accumulated by age 34, €20,000 was made up of contributions he/she had made and the balance of €6,798 came from returns on the monies invested. For the first ten years, then, it was more about what Investor A had invested than about the returns. But once he/she had accumulated some capital, compounding did the rest and over the next 31 years until retirement at age 65, Investor A generated €271,234 of returns without having contributed another euro.

No wonder Warren Buffett's biography is called Snowball. Build a small snowball, roll it downhill and watch it grow on nothing more than its own weight.

Now that is the power of compounding, and it can set you financially free!

And here at GillenMarkets, we put this concept into practice through our live 'Regular Investor Growth Portfolio'. On the 3rd Friday of each month we invest €1,000 in real cash into a stock or fund from the list of stocks and funds recommended on our website. We believe that the Regular Investor slot is one of the most useful aspects of the GillenMarkets website, as it provides real and ongoing accountability regarding the quality and consistency of our recommendations as well as making it easy to follow.

Compared to saving with non-risk assets such as bank deposits or government bonds (which still offer little to no return at the time of writing), the Regular Investor approach offers two principle advantages:

  • It significantly reduces the risk of mis-timing your entry (i.e. investing only when markets are possibly overvalued). Investing in good times and bad irons out the volatility and means that you are investing when markets are undervalued as well as sometimes when they are overvalued.
  • It allows you to methodically obtain the superior returns that stock markets have traditionally delivered. Over the long-haul, stock markets have delivered returns of circa 5% above inflation annually, which compares to 1% for bank deposits.

Subjective Growth Portfolio - Track RecordThe chart on the right highlights the progress of our Regular Investor's portfolio since it was first launched on the website in November 2009. To date, by investing €1,000 each month a total of €105,000 has been invested - and investing in good quality stocks and funds that we recommend, your monies would now be worth €188,103. This represents a total gain of 79.1% and a 11.7% compound per annum return over the 9-year period.

The aim of this article is to demonstrate to readers that starting a savings programme and building an asset gives you choices later in life; the choice to perhaps retire early, the choice to take a year off and do a world tour, among many other choices. Financial freedom is an attractive goal in life for many, and our view is that it is within the grasp of everyone in society.

GillenMarkets exists to assist private investors to develop a sound savings and investment plan. That includes the person just starting out who can save and invest regularly over his/her lifetime to the person with pension assets to the person with a lump-sum to invest. We can assist in the following ways:

  • We hold 1-day investment training seminars that empower you to become a successful investor. You don't need to be Einstein to understand investing and to start a sound investment plan. Our next seminar is in Dublin on Saturday, 8th September.
  • We have Ireland's only subscription-based investment newsletter that allows you to access impartial investment advice and sound investment suggestions along the way.
  • We provide wealth management services for those who don't wish to do any of the investing for themselves. Many are time poor, don't have the interest we do or simply recognise that they get too emotional when market conditions deteriorate.

If you have an interest in any of our three services just contact the office by telephone (01 2871400) or by email to info@gillenmarkets.com and we would be delighted to hear from you.

Rory Gillen

Founder, GillenMarkets

17th August 2018