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Compound Growth = Growth on Growth

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Albert Ein­stein sup­pos­ed­ly once said that the most pow­er­ful force in the uni­verse is com­pound inter­est. Nat­u­ral­ly, investors seek com­pound growth, but they often fail to cap­ture its full ben­e­fit.

The prin­ci­ple of com­pound growth can be defined as the pow­er of expo­nen­tial growth, that is, growth on growth. It’s like a snow­ball effect where­by you receive growth, not only on your orig­i­nal invest­ments, but also on any inter­est, div­i­dends, and cap­i­tal gains that have accu­mu­lat­ed — thus, your mon­ey can grow faster and faster as time goes on.

Recent­ly we released a white paper called “Math Mat­ters: Rethink­ing Invest­ment Returns & How Math Impacts Results.” The choice of a title was delib­er­ate: math real­ly does mat­ter to the ulti­mate suc­cess or fail­ure of an invest­ment plan.

How­ev­er, the irrefutable truths of these math­e­mat­i­cal prin­ci­ples some­times get lost when fear and greed take over the investor’s mind. The white paper seeks to for­ti­fy ratio­nal investors by prov­ing the impor­tance of four math­e­mat­i­cal con­cepts, name­ly:

  1. The impor­tance and pow­er of com­pound growth
  2. The impor­tance of avoid­ing large loss­es to returns
  3. The impor­tance of vari­ance drain / volatil­i­ty drag
  4. The val­ue of a non-nor­mal dis­tri­b­u­tion of returns

In future blog posts we will dis­cuss the lat­ter three points, but this post is focused upon the pow­er of com­pound­ing returns.

While it sounds sim­ple, the con­cept of com­pound growth and its impact can be a dif­fi­cult one to grasp.

Why is com­pound growth so impor­tant and how does it impact the returns one might achieve with an invest­ment?

One of the best ways to illus­trate the pow­er of com­pound growth is through a sim­ple hypo­thet­i­cal illus­tra­tion.

Compound Growth | Swan Blog

There are a few key take­aways from this illus­tra­tion.

  • First, it takes a while for the pow­er of com­pound­ing to real­ly take effect.

After 20 years, an ini­tial invest­ment of $100,000 that grows at a 12% annu­al rate is worth $964,629; a gain of $864,629. Not bad at all. How­ev­er, over the fol­low­ing 20 years that $964,629 grows to $9,305,097, an increase of $8,340,468 (high­light­ed in the table below). That is the pow­er of com­pound­ing returns.

The sep­a­ra­tion in the lines of the chart above, and the dif­fer­ence between the num­bers in the table below, is not sig­nif­i­cant until years into the invest­ment time­line. That means investors need to remain invest­ed to allow for the time that com­pound growth needs to work its mag­ic.

Compound Returns | Swan Blog

Viewed anoth­er way, the dif­fer­ence between a 10% annu­al rate of return and a 12% annu­al rate of return on an ini­tial invest­ment of $100,000 is only $291,879 after 20 years: $672,750 vs $964,629, respec­tive­ly.

How­ev­er, after 40 years the dif­fer­ence is immense. Those extra 200 basis points will more than dou­ble the val­ue of an invest­ment: $4,525,926 at 10%, $9,305,097 at 12%.

Of course, this is a the­o­ret­i­cal exam­ple meant to illus­trate a math­e­mat­i­cal point. In the real world, it’s safe to say no one has ever seen an invest­ment that has pro­vid­ed a con­stant 10%, 12%, or 15% annu­al return over 40 years with zero volatil­i­ty, or fluc­tu­a­tion in val­ue over a giv­en peri­od.

This high­lights the sec­ond major take-away from this illus­tra­tion:

  • Volatil­i­ty or loss­es will have a big impact on the end­ing wealth of any sce­nario.

The hypo­thet­i­cal case above rep­re­sents an ide­al sce­nario: pos­i­tive returns with no risk, no volatil­i­ty, and no loss­es. In the real world any­thing that caus­es a “reset” to the val­ue of an invest­ment will be detri­men­tal.

 

In con­clu­sion, yes, com­pound returns are a won­der­ful thing. How­ev­er, the com­pound­ing pow­er will be severe­ly under­mined by large loss­es and volatil­i­ty. The extent to which large loss­es and volatil­i­ty can lim­it or even over­whelm the pow­er of com­pound­ing returns will be explored in future blog posts in this series.

Click to learn more about Swan’s DRS invest­ment approach is designed to help investors remain invest­ed and reduce volatil­i­ty. For more infor­ma­tion please con­tact Swan at 970–382-8901.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Impor­tant Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it swanglobalinvestments.com. 154-SGI-062816

By | 2017-08-08T12:04:44+00:00 June 28th, 2016|Blog|Comments Off on Growth Creates Growth- Applying the Power of Compound Growth