How compound costs can destroy your long term investment returns

“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 closer look at where some of these costs are incurred - you can read that here. Bogle’s point is that when trading costs are compounded over time they can have a devastating impact on returns: “Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.”

Over-trading damages wealth

Unfortunately, evidence suggests that many investors trade too frequently to the detriment of their returns. Back in 2000, academics Barber and Odean analysed the positions and trades of around 65,000 US investors and found evidence that their self-managed stock portfolios underperformed the market mainly because of trading costs. The 20% most active traders earned an average annual return after costs of 11.4%. But the 20% who traded the least earned 18.5% after costs. More alarmingly, the average portfolio churn rate of the most active traders was 258% - they were turning over their portfolios more than twice each year!

Individual investors are regularly drilled on the advantage they have over fund managers, given that they can act fast and trade in small amounts of shares. But it’s perhaps worth listening to the advice of some of the most successful managers. Terry Smith’s Fundsmith Equity Fund has produced a 16.8% compound annual total return since 2010. Last year that fund only added two new positions and sold one.

As Smith explains, there are three key factors in his investment approach: “Firstly, we identify good companies, secondly, we buy their shares at a fair or better price, and lastly we seek to do the most difficult thing of all, nothing. In this way we allow the great returns that our portfolio companies generate to mount up and compound their share prices.”

With a rule-based investment strategy in place, one of the hardest jobs for investors, as Smith points out, is to do nothing. It’s important to remember that the power of compounding is a two-way street. Racking up costs through over-trading over the long term will land you with too much of the wrong sort of compounding.

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