How Money Doubles — Understanding The Law of Compound Returns

Posted on August 9, 2010 at 4:34 PM PST by

The latest biography on the world’s most famous investor is titled “The Snowball – Warren Buffett and the Business of Life.” The term “snowball” is a metaphor for a core investment concept: the Law of Compound Returns. Understanding it is critical to your success as an investor and should be at the center of all your investment decisions.

Think of the Law of Compound Returns as a force of nature that describes how wealth grows. A small snowball rolling down a hill will gather 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.

If you achieve a higher rate of return for many years, your wealth can snowball into a fortune. For example, from 1925 – 2003 a portfolio of bonds smoothly appreciated an average of 5.4% per year (dry snow) snowballing to 61 times its original size, while a portfolio of US stocks appreciated 10.4% (wet snow), snowballing to over 2200 times its original size. But higher returns require that you stomach large portfolio fluctuations. During this period US stock investors endured depressions, wars and periods of stagnation, as the bond holders calmly clipped coupons and watched their capital depreciate.

Your job as an investor is to find a level of risk that you can live with and then structure the most efficient portfolio that delivers a rate of return commensurate with the level of risk you are assuming. Then you must help the Law of Compound Returns work its magic.

At MarketRiders, we can’t give you a longer hill, but we can help keep your snow wet. Taxes, investment fees, and underperformance interrupt the Law of Compound Returns and lower your returns. They dry out your snow.

First, using low fee ETFs and investing with our software lowers your fees and increases your returns without assuming any more risk. Second, deferring taxes lets more money continue to snowball year after year. Trading in and out of ETFs can increase taxes and takes a bite out of the snowball as it rolls down the hill. That is why we recommend ETFs that are well-constructed indexes that you’ll never have to sell. After you’ve held your ETFs for a year, small gains from rebalancing are taxed at the lower long-term capital gains rate. And finally, since ETFs mimic an index they will have good and bad years. But, unlike an investment manager, an ETF will never lose your money betting on an investment theme that didn’t pan out.

Take a minute to play with this calculator to see how much your money will snowball given different rates of return and time horizons.

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