Compound Returns - Investing with the Most Powerful Force in the Universe

2 December 2016  |  Simon Miller
Compound Returns - Investing with the Most Powerful Force in the Universe
Investors underestimate the impact of compound interest.
But even small differences in fees can make a big difference in the long term. Investors should bear in mind that every pound they spend in management fees will not generate a return for them in the future and therefore slows down their wealth creation.

Becoming a millionaire is a dream shared by many. This explains the worldwide success of Chris Tarrant’s iconic show Who Wants to Be a Millionaire?. For most of us, being a millionaire means never having to work again, or at least never having to worry about money.

But is there a successful recipe for becoming a millionaire? Typical advice would be to work hard in order to increase your salary, spot a market niche and build a business empire, or to get lucky by inheriting wealth or winning the lottery. Starting to save early in your life and investing those savings intelligently, however, is much less frequently mentioned – maybe because this sounds rather dull. However, it is actually the safest and most straight-forward route to becoming a millionaire. Investing for the long-term, which is only possible when you start way ahead of your retirement, allows you to go for a higher risk profile, typically generating higher returns. If you can combine this with low costs, you’re well on track to reach everyone’s dream without having to hit the jackpot.

Time Is Money – in every sense of the word

The Value of the Portfolio is One Third Higher Due to Compound Interest

Development of £100 initial investment, assuming a 5% annual interest

Development of £100 initial investment, assuming a 5 percent annual interest rate

Past performance or future projections are not indicative of future performance.

When asked what he thought to be the most powerful force in the universe, Albert Einstein allegedly answered ‘compound interest’. This notion refers to the exponential growth effect in wealth creation that sets in when you keep the returns that an investment generated in a given year invested over the next couple of years. Interest, dividends and capital gains which are reinvested start generating a return that over time can outweigh the return generated from the originally invested amount.

A few examples show the astonishing effect of compound returns. Assuming you invest £50,000 today and get an annual return of 8 percent over 40 years (which is the average annual return on a large stock index like the FTSE 100 or the American S&P 500 over the last 30 years), you can expect to cash of over £1 million at the end of the investment period. This means a 25-year old who invests this sum over the course of 40 years can likely retire without financial worries.

Obviously, only a few people in their mid-twenties already have £50,000 to invest. But this is also relevant at the age of 35 when many people are already well on track on their career path and have been able to save money for a few years. Let’s say that between the age of 25 and 35 they have been able to save £10,000 per year on average, perhaps helped by the addition of a small inheritance. With an initial investment of £100,000 at age 35, a balance of £1.1 million can be achieved after 30 years with an annual return of 8 percent, thanks to compound interest. So if you start investing in your mid-thirties, you could be a millionaire when you retire – and of course, had the investor started to invest a smaller amount earlier already, their retirement pot could even exceed the £1.1 million.

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it

– Albert Einstein

The two examples illustrate that postponing investing by 10 years means that you might need twice as much initial capital to achieve the same goal – just because you have missed the tailwind provided by compound returns in the first 10 years.

Rule 1: Thanks to compound interest, the earlier you start to invest, the less capital you need to become a millionaire – assuming that the returns on your investment are stable over time.

Fees can cost a fortune

Another crucial factor affecting how much you can benefit from compound interest is the cost of your investments. Even a small difference in fees can have a significant impact since you cannot benefit from compounding on money you’ve paid in fees to a third party. Paying an extra percentage in fund or investment management fees can end up costing you the equivalent of a small car, an apartment or even a house by the time you reach retirement. And wouldn’t you rather spend that money on showering your grandchildren with presents or going on a cruise when you’ve retired?

An extra pound you pay today is not only not in your pocket in 30 years – it delivers a return year after year and thus cannot contribute to your wealth creation. The effect is a lot more drastic than most investors imagine. Our chart shows an example for illustration.

1% Higher Fees Can Cost a Fortune

Comparison of wealth creation assuming a 6.5% annual return and £100,000 initial capital

Comparison of wealth creation assuming a 6.5% annual return and £100,000 initial capital
Source: own calculations
The gross annual return assumption is 6.5% and is based on the historical performance of the ARC £ Steady Growth Private Client Index from January 2004 to March 2017.

Past performance or future projections are not indicative of future performance.

If you pay 1 percent in annual fees on an initial investment of £100,000 over the course of 30 years, you will achieve a final portfolio value of £498,395, assuming returns of 6.5 percent p.a. However, if you pay 2 percent in fees you end up spending the equivalent of several cars on the total fees because instead of reaching a portfolio value of £498,395 you end up with just under £375,000.

It is, therefore, important to pay particular attention to fees when investing. The Total Expense Ratio (TER) or ‘ongoing charges’ indicate the annual cost of an investment fund. In addition, however, investors must also factor in performance fees (in case there are any), the typical bid/ask spreads for buying or selling a fund and transaction charges that might not be included in the TER or ongoing charges. For many funds, the total cost adds up to 3 percent per year or even more.

Studies have shown that actively managed funds are generally unable to beat their benchmark. This was recently also confirmed by the UK regulator, the FCA. One reason for this is their cost burden. For an Exchange-Traded Fund, however, there is no need for expensive fund managers and research teams, as the fund merely replicates an index such as the FTSE 100, the Eurostoxx 50 or the MSCI World. As a result, these passive funds are more cost-effective and transparent than traditional, actively managed equity funds run by asset managers.

Rule 2: Avoid high fund charges and management fees. When you invest, you get what you do not pay for!!

Bild: NASA/ Unsplash.com

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Simon Miller
UK CEO & UK CO-FOUNDER
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.