By: Tim Bennett
25.07.2019
25.07.2019
Our inability to process big numbers may mean we never take full advantage of the miracle of compound returns, as Tim Bennett explains.
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Why investors’ brains can’t cope with compound growth
To take advantage of one of investing’s only, and biggest, free lunches, you must override your mental hard-wiring and grasp the power of compounding. Here is why this is harder to do than you might think.
Background
The ability to earn interest on interest – known as compound growth – is one of finance’s most powerful secrets. Yet, it can elude many investors. That is not entirely their fault.
The linear brain problem
To illustrate this, consider a simple sum 4+4+4+4. The answer won’t fox many people – it is 16. But now try 4x4x4x4. Some will get the right answer, but it is a much harder sum to crack. The reason is that we are programmed to think linearly rather than geometrically and yet the compound returns that underpin investing are built on the latter.
If you found the two challenges above easy, then we can move onto to something bigger. Let’s take the challenge of doubling. Why? Over the past ten years, the S&P 500 index in the US has roughly doubled. Doubling also underpins the famous “rule of 72” that says you can work out how long it will take to double your money at a set growth rate by dividing 72 by that rate. So far, so straightforward, until you start to extrapolate over more than a few periods.
The folded paper effect
Let’s say you have a piece of paper and you fold it in half, doubling its width. Then you do it again, doubling the existing width. How tall will the paper stack be after 50 folds? The answer may surprise you below;
Next, we turn to chess.
The chess board challenge
This time let’s say you put a grain of rice on the first square on a chess board. Then two on the second, four on the third and so on. How many will there be on square 64? Again, not many people can estimate this correctly.
The domino effect
One more example, for good measure. This time you put a conventional domino on its head. Then you increase the size of the second one by 50% (not doubling the height this time). The third is then another 50% taller than the second and so on. How tall will number 32 be?
At this point you might be thinking, so what?
Closer to home
These three somewhat extreme examples are there to make the point that people sometimes fail to grasp how powerful compounding can be, even if the rate of growth is a lot less than 100% or 50%. Take the challenge of building a £1m retirement fund over 40 years. It sounds daunting but actually on a monthly basis, the amount needed at a decent growth rate isn’t as high as you might think.
Rules of compounding
To make this force of finance work for you, don’t forget the key principles below. There are others two, such as de-risking your exposure as you approach a key drawdown but I deal with these in other videos. The key message of this one is don’t let your brain let you down when it comes to long-term returns!
To find out more
An Investment Manager will be very happy to talk about this at more length, or feel free to email me at the usual place as [email protected].
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