Remember the Law of Compound Returns

Posted on August 19, 2011 at 2:15 PM PDT by

When the markets get turbulent as they are today, investors get emotional. We want to react. Today is a fear day, but last month there were greed days. On fear days, we react. We wonder, “How much more money can I lose? Should I be getting out?” On greed days, we get excited and after looking at what we “shoulda, woulda, coulda” done, we get anxious and may buy into a rising tide.

But what is the purpose of investing? It sounds like a stupid question, but ask 10 investors, and you’ll get a surprising variety of answers. Is there an answer that allows us to conduct ourselves in a rational way that is not influenced by fear and greed?

Try this out. A recent 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.

Trading, taxes, and fees. Management fees and taxes dry out your snow. A small difference can mean the difference between having a boulder when you retire, or a snowball. Have you checked the taxes you’re paying on your mutual funds? It’s probably taking 1 to 2 percent off your returns because managers change all the stocks out an average of once every 18 months. Mutual fund charges, broker, or advisors fees on portfolios average 2 percent. But index funds and ETFs run about 0.25 percent. You might not think that’s a big difference.

But here’s how it is. Take a $100,000 portfolio. Using the market’s long-term average growth of 10.4 percent a year, compounding your gains over 20 years, and deducting the 3 percent in fees and taxes, you’d have $287,928 after taxes. But if your fees and taxes were 0.25 percent instead of 3 percent, you would have $607,465. That’s over a 100 percent difference! That’s double your money. All based upon a tiny difference in fees and taxes of 2.75 percent.

How quickly will your money double? Einstein’s “Rule of 72” says if you take your yearly percent return and divide into 72, you get the number of years it takes to double your money. Let’s start with $100,000. If you have a 9 percent return (divided into 72), your money will double in eight years ($200,000). In another eight years, you would have $400,000, and so on. But if you get a 6 percent return (divided into 72), your money will double every 12 years ($200,000). Within 24 years, someone getting 9 percent will have twice as much as someone getting 6 percent.

Here’s an answer to the initial question. 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. It is not to compete against the stock pickers and market timers on Wall Street—or even hire one to manage your money.

No one can give you a longer hill—your age and personal working situation define your time horizon. But you can keep your snow wet. Taxes, trying to time the market, paying large investment fees, and making investment mistakes interrupt the law of compound returns and lower your returns. They dry out your snow.

So when the market has ups and downs, remember that if positioned correctly, your portfolio will grow over time—capitalism demands a return. Your job is not to react to your fear and your greed, but rather to stay out of the way, remove the obstacles to the law of compound returns, and let this force work its magic on your money.