The law of compound returns is a force of nature and understanding this concept is critical to your success as an investor. It is how the rich keep getting richer, but maybe not how you are led to believe.
Simply put, the law of compound returns says money left alone creates more money. Einstein said, “Compound interest is the eighth wonder of the world.” Ben Franklin echoed that thought, saying, “Money can beget money, and its offspring can beget more.” Warren Buffett’s partner Charlie Munger expressed a similar sentiment about money: “Never interrupt it unnecessarily.”
Think of the law of compound returns as a small snowball rolling down a hill gathering weight, which increases its speed, which keeps increasing its size. Wet snow and a long hill are the conditions that turn a snowball into a very large boulder. Continuing with the metaphor, snow moisture relates to an investor’s rate of return, and the size of the hill is one’s time horizon.
Your job as an investor is to find a level of risk that you can live with and then structure an efficient portfolio accordingly. Then you must let the law of compound returns work its magic.
No one can give you a longer hill, but your investment choices will determine if your snow is wet. Taxes, investment fees, and underperformance interrupt the law of compound returns and lower your returns. They dry out your snow.
Using exchange-traded funds can lower fees by 80 percent, which helps you keep more of your returns. But remember: Trading ETFs frequently can increase taxes and take a bite out of the snowball as it rolls down the hill. The less trading you do the longer you can defer taxes, which leaves more money to snowball year after year. After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate. And because most ETFs track indexes, you will never lose your money betting on investment themes that don’t pan out.
The “law of 72″ helps us understand compounding. Divide your yearly return by 72. The result is the number of years it will take for your money to double. Money doubles every 12 years with a 6 percent return and every eight years with 9 percent. That means if you are 40 years old, a $100,000 investment with a 6 percent return will double twice to $400,000 by the time you are 64 years old. At 9 percent, it will double three times to $800,000! If you achieve a consistent higher rate of return for many years, your wealth can snowball into a fortune. But you have to live some with volatility.
Inflation is the dark side of the law of compound returns and determines how your savings deteriorate over time. Assuming real inflation is 4 percent per year, with the law of 72 that means every 18 years prices double, and your money will buy half of what it did before. As an investor you fight the reality that 20 years after you retire your money will lose 50 percent of its buying power.
The law of compound returns is a slow, powerful, and largely invisible force that you can’t ignore. Because of how it operates with inflation, your money will be worth half of what it is today in 18 to 24 years. But if you can reduce your fees, taxes, and increase your returns by just 2 to 3 percent per year, you’ll double your savings in 24 years.