“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett
Compound interest is one of the most powerful tools that investors can use to maximise returns over the long term. All it takes is time and discipline. By allowing returns to build up year upon year, even a modest initial investment can snowball into something far, far larger. But the power of compounding doesn’t stop there. It also has a sinister side that can just as easily wipe out a fortune. To avoid this happening it’s important to remember that trading costs can compound in exactly the same way that returns do.
Let’s say you invested £10,000 in the stock market at an (albeit improbable) 15% return. Without taking trading costs into account, your return after 10 years would be £40,455. After 20 years, the rate of growth would be accelerating exponentially and your capital would have grown to £163,665. That’s more than 16 times your money in 20 years. This is the magic of compounding: the combination of time plus the rate of return creates a snowball effect that produces incredible results. You can read more about how it works here.
Now, let’s get real and take costs into account (but not inflation). Say that the costs of buying and selling shares sliced 3% per year from your rate of return, reducing it to 12%. Bear in mind that in some active funds, costs of 3% (both advertised and hidden) aren’t unusual. Likewise, individual investors who churn their portfolios frequently also risk incurring considerable costs. So, with a 12% return, over 10 years your capital would grow to a much leaner £31,058. And over 20 years you’d be sitting on £96,462. In other words, the effects of those compounded costs over 20 years slashed £67,203 from your overall return!
Tyranny of compounding costs
In The Little Book of Common Sense Investing, John Bogle, a pioneer of the low-cost index fund industry and founder of Vanguard, describes this as “the subtle tyranny of compounding costs”. Naturally, he reserves most of his criticism for the active fund management industry. He says that investors pay too little attention to management fees, operating expenses and sales charges. But he also points out the ‘hidden’ costs that affect all investors, such as broker commissions and spreads. Earlier in our series on Portfolio Management we had a…
