Compounding increases and accelerates wealth accumulation. Albert Einstein famously said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Successful investing maximises return for a given level of risk, but compounding amplifies that growth over time.
The beauty of compounding is that while growth initially adds only small amounts to an investment, returns soon accelerate because you are compounding growth on larger and larger amounts.
Three ways to make compounding work for you:
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Where to invest to maximise the benefit of compounding
Over the long term, the asset class that has most reliably generated real growth is equities. While passive investing (investing in a fund that tracks the market) may be a low cost alternative, investors may be foregoing much of the potential benefit of alpha and compounding by using this approach.
Invest in an active manager who has a proven history of generating outperformance
With many commentators believing that lower real returns from all asset classes is likely in the future, outperformance (known as alpha) of as little as 1– 2%pa can become a major factor in achieving long-term investment targets.
In spite of this, passive investing is growing in popularity around the world, based on the myth that this approach produces better performance net of fees.
This is largely due to two reasons:
- Passive investing is cheap. High fees can also compound, eat away at clients’ money and reduce returns over time. We all know the impact that fees can make on a 30-year investment. But when did you last think about the opportunity cost of losing 2%pa alpha? The difference on $10,000 invested for 20 years at an 8% return ($49,268) versus a 10% return ($73,281) is $24,013, or around a 50% difference of the total investment.
- Labelling is easy. When the ‘active versus passive’ debate is publicised, comparisons that support popular headlines group all active managers together. Active managers are not one homogenous group and many large managers are ‘quasi’ index managers. So these comparisons are not strictly correct. Proven stock pickers who don’t follow their benchmark index are harder to find. But they can also offer significant alpha.
Time is important: start early and be disciplined about remaining invested.
The longer you have to allow compounding to do its magic, the better off you will be. This means that it is a good idea to start investing and searching for those managers who can add value as early as possible.
Lastly, be emotionally disciplined, and if you can’t do this on your own, get professional advice.
JD de Lange is the Head of Retail at Allan Gray Australia
