April 5, 2019
Compounding builds value. Its usual domain is finance, but compounding applies to other things, too. Isaac Newton said this:
“If I have seen further, it is by standing on the shoulders of giants.”
Compounding grows value – whether the value is denominated in knowledge or in financial terms. Isaac Newton compounded his knowledge with the knowledge he acquired from others. The discipline of finance takes Isaac Newton’s compounding of knowledge and expresses it as an equation applied to investment value. The beauty of this equation lies in its simplicity and relevance:
Value grows by a greater amount every period (e.g., year) and depends only on the number of compounding periods and growth rate.
If investors reinvest dividends, interest, and capital gains, the equation reveals the power of compounding. For example, after ten years, a $1,000 investment growing at 3% per year gains $344. After twenty years, value increases $806, more than double the amount it grew in the first ten years. After twenty years with a 6% growth rate, value grows faster, and the increase in value, $2,207, is more than double the increase on the 3% investment for the same period.
Of course, all investment decisions must consider risk. Successful investors accelerate compounding by managing three factors: 1) risk, 2) the number of compounding periods, and 3) growth rate. The next few paragraphs detail practical ways to manage all three factors to accelerate compounding.
Method 1: Set a Goal and Invest for the Long-term
The first step in accelerating compounding sets an income goal. This takes a little time and simple calculations. For example, assume you set an annual income goal of $50,000 from the interest and dividends your investments will yield. How much investment value must you accumulate to earn $50,000? Divide the goal by the expected interest/dividend rate you’ll earn. A 4% rate means you divide $50,000 by .04: $1.25 million. But what if your investments earn a higher rate during retirement, say 8%: You’d only need to accumulate $625 thousand.
Action Plan: Set a goal and plan to work toward that goal every month.
Method 2: Maximize Compounding Periods
You’ve settled on a future income value, and you know how much to accumulate. The next question is how much you need to save to achieve the goal.
Assume you currently have $10,000 saved, your goal equals $1 million, and you have 20 years to accumulate it. You figure an 8% growth rate for 20 years. The investor.gov calculator, which uses the compounding formula, says you’d need to set aside $1,736 every month to accumulate $1 million.
But wait! To accelerate compounding, what if you had 40 years to save, instead? You’d only need to set aside $251, about $1,485 less each month!
Investors should start saving early. In fact, of the things over which investors have control, nothing accelerates compounding more than starting early.
Action Plan: Even if you can’t put aside as much as you should to achieve the goal, it pays to get in the habit of paying yourself first now rather than later. We think automating investment contributions works best.
Method 3: Manage Portfolio Risk with Broad Allocation, & Diversification
Investors must assume risk to earn investment returns greater than the inflation rate. However, assuming risk means returns might not exceed inflation. It’s a conundrum. Part of the solution lies in broad allocation, which addresses the “don’t put all your eggs in one basket” adage. Broad allocation reduces the impact of insolvency or a protracted decline in a business or market.
The other part of portfolio risk management rests with a reduction in portfolio volatility created when individual investment returns don’t always change in the same direction at the same time. The term is correlation. When investments inside a portfolio have low correlations – they don’t always change in the same direction at the same time – and portfolio value is less volatile. Some investment values go up when others stay the same or go down.
Action Plan: Broadly allocate by including many kinds of investments in your portfolio. But do so thoughtfully by selecting investments with low correlations. Bonds have low correlations with other kinds of investments, but their yields tend to be low. For example, U.S. Treasury bond yields have ranged from 2 – 3% for the last ten years or so. Real estate investments offer the potential for diversification and much higher returns.
Method 4: Maximize Compounding Rate/Investment Returns
Here’s where some investors derail. They chase returns and it can get them in trouble. On the one hand, investors seek high rates of return. On the other hand, higher returns usually indicate higher risk. The adage says there is no free lunch in investing. That’s why broad allocation and diversification are so important. But think about this: Doubling investment return more than doubles the growth of investment value.
Consider two investments. One earns 8%, the other earns 16%. The 16% investment pays twice the rate. However, the 16% investment grows investment value more than double the investment growth of the 8% investment. For example, a $1,000 investment earning 8% gains $1,159 after 10 years. A 16% investment gains $3,411 over the same 10-year period. Even though the growth rate doubles, the increase in value is about 2.9x!
Action Plan: Remain fully invested and don’t time the market by chasing returns. Reinvest interest, dividends, and capital gains. Use commercial real estate to help grow value. We believe commercial real estate offers the potential for high returns and low correlations. Whereas stocks have earned around 9.5% over the past 20 years, real estate investments have earned 10.6% or more. For most investors, real estate investment trusts (REITs) offer the most efficient exposure to this sector, and REIT returns have been high at an average annual return of 11.8%.