Compounding - it’s about the end game

Taking a brief look back at 2022, it was one of the most challenging years in recent history for global financial markets.

Taking a brief look back at 2022, it was one of the most challenging years in recent history for global financial markets.

Published May 28, 2023


By James Newell

Having recently enjoyed reading Morgan Housel’s “The Psychology of Money” I was reminded of the crucial role compounding can play in multi-generational wealth creation. While the stories about arguably the greatest investor of our time, Warren Buffet, are legion, this one I didn’t know. By James Newell

Unlike most of us, Buffet had become somewhat of a seasoned investor before reaching his teens. His investment track record is certainly impressive, but it’s the length of investment horizon that has been just as impactful on his success. Housel notes that of Warren Buffet’s $84.5bn wealth (at the time of penning his book), $84.2bn of this was generated after Buffet’s 50th birthday.

In other words, 99.6% of his wealth was generated after reaching the age of 50. He only became a billionaire at the age of 56. Buffet, now 92, has been blessed with longevity that has allowed him to exploit the power of compounding over what is now more than 80 years.

Compound growth enables an asset to achieve exponential growth through the reinvestment of (and subsequent growth on) prior returns. The longer the period over which exponential growth can be achieved, the greater the impact will be.

If for example we started with R1m and achieved a return of 10% the value of growth in the first year would equate to R100 000 and we would now have a total of R1.1m to invest. If we continued to invest the initial R1m as well as all the growth over time, achieving 10% return each year, by the end of 10 years our end value will have grown to more than R2.5m and the 10% return that would be achieved in year 11 would be more than R250 000. Essentially, the amount of annual growth will have become more than 2.5 times as much as it was in the first year, thanks to the effects of compounding.

It’s clear the exponential trajectory of compound return means that the discipline of patience and passage of time is required to maximise its benefits. There is, however, another important factor that can have a profound impact on the compounding effect and ultimately play a pivotal role in long-term wealth creation – the ability to avoid periods of significant negative return or single loss events.

Looking again at our earlier scenario of R1m and growth of 10% per year over a period of 10 years, this would result in an end value of just over R2.5m at the end of 10 years. However, if we considered a decline of -20% in the first year followed by 10% growth in each of the subsequent 9 years, the end value after 10 years would be just less than R1.89m. This is 37.5% less in value than would be the case had growth been 10% every year for 10 years. To look at it differently, after a 1st year decline of -20%, the investment would need to grow by almost 14% per year for the next 9 years to generate the same level of total return that would be achieved by constant growth of 10% per year over 10 years.

Asset correlation can upset the apple cart

Taking a brief look back at 2022, it was one of the most challenging years in recent history for global financial markets. Equity and fixed income markets typically react differently to various market conditions, which allows portfolio volatility and short-term drawdown to be managed by actively diversifying across these two broad asset classes. However, in response to soaring inflation and a resultant path of interest rate normalisation we experienced unusually high levels of correlation between these asset classes, both of which suffered significant declines during the year.

At times of heightened market volatility and/or dislocation, as was experienced last year, one may feel that de-risking a portfolio entirely and “sitting on the sidelines” is the best solution, however this often results in crystalising losses at just the wrong time and needing to make an incredibly difficult decision on when to get back in. In effect, an emotionally driven decision to find short-term relief often comes at a significant cost in the form of long-term destruction of wealth.

One of our most important roles as investment managers is to help guide clients through these situations and avoid decision-making that may be entirely at odds with the intended investment objective, but more importantly which results in the permanent loss of capital. Sticking to a well-defined, long-term strategy coupled with the power of compounding over multiple market and economic cycles is, in our view, one of the most effective ways of achieving multi-generational wealth. When considering an investment horizon as long as 80 years, the results are quite staggering.

*Newell, Director at Stonehage Fleming Investment Management South Africa.

** The views expressed do not necessarily reflect the views of IOL or its sister titles.