Chapter 27. What Really Determines Your Long-term Investing Results?

Chapter 27. What Really Determines Your Long- term Investing Results?

At this point, you need to ask exactly how your long-term investing results are determined. To understand how mutual funds or any other alternative accomplishes wealth building, let's examine the underlying basis of all investing success. It really comes down to a simple notion.

Insights

Investing success depends on the following factors:

1. How much money you save and invest and when.

2. What rate you earn on invested funds (which in turn is related to how much risk you are willing to take).

3. How long you hold the assets.

The magic ultimately occurs because of compounding , truly one of the great benefits of modern financial society available to investors. The power of compounding over time is simply incredible in terms of the results produced. For any given dollar amount invested, the longer the time period and the higher the compounding rate, the greater the terminal wealth.

So, let's consider some examples of how wealth is built over time. Assume an investor starts out with $10,000, and invests in a safe asset paying five percent compounded on an annual basis. Table 27-1 shows the dollar amounts at the end of the specified periods that this investor would have.

Table 27-1. Results of $10,000 Invested at Five Percent Compounded Annually

At the End of	The Amount Accumulated Is
5 years	$12,763
10 years	16,289
15 years	20,789
20 years	26,533
25 years	33,864
30 years	43,219
35 years	55,160
40 years	70,400

By compounding, we mean simply that interest is being earned on interest as time passes . If the interest in this example is paid at the end of the year, the investor has $10,500 at the end of the first year. For the second year, the investor earns five percent on the new balance of $10,500, resulting in a balance of $11,025 at the end of the second year.

If interest is not compounding, the interest earned is simply added to the account each year, and for the next year the investor earns the same interest rate on the same beginning principal amount. In our example, the principal is $10,000 and the interest rate is five percent. In this case, the investor would have, at the end of the second year, $10,000 + $500 + 500, or $11,000.

In this example, our investor has gained $25 as the result of compounding. Such gains start to accumulate quickly and have a pronounced effect on subsequent results.

Notice that the results after 10 years are not double those of five years, nor is the 20-year result double that of the 10-year result, but the 30-year accumulation is more than twice that of the 15-year accumulation. For 40 years, the accumulation is considerably more than double that of 20 years.

Such is the power of compounding over long periods of time. Money grows at a nonlinear rate, picking up speed as the time period grows or the rate of compounding increases . As a result of compounding, money grows at an exponential rate, which for our purposes means an accelerating rate and not simply a proportional rate.

The rate at which money grows when compounding is illustrated in Figure 27-1. This figure uses $1,000 as the beginning amount to clearly illustrate the point. If we were simply adding five percent a year to $1,000, the total at the end of each year would grow as illustrated by the straight line ”a steady, proportional growth. However, with compounding, the growth rate is exponential, which means the growth is accelerating with time. Hence, the curvilinear relationship that depicts compound interest is sweeping upward.

Figure 27-1. Simple versus Compound Interest Over Time, Starting With $1,000 and an Interest Rate of Five Percent.

Now assume our investor earns an annual rate of six percent, only one percentage point more. The changes in wealth can be substantial as the investor now compounds at this marginally higher rate, as shown in Table 27-2.

Table 27-2. Results of $10,000 Invested at Six Percent Compounded Annually

At the End of	The Amount Accumulated Is
5 years	$13,382
10 years	17,908
15 years	23,966
20 years	32,071
25 years	42,919
30 years	57,435
35 years	76,861
40 years	102,857

As you can see, with a small change in the rate of return, from five percent to only six percent, after 40 years the difference in ending wealth is more than $32,000. Such is the power of compounding over long periods at a slightly higher rate! Never underestimate the value of a small increase in your rate of return if you are able to compound over long periods of time.

Next, let's consider a rate of return of 11 percent, which is the (approximate) long-run compound annual average rate of return that would have been earned on the S&P 500 Composite Index from 1920 through 2000. This is a total return number, assuming that dividends were reinvested.

For a 40-year period, an initial investment of $10,000 would grow to $650,009. Notice that relative to the 6 percent example, we did not double the rate of return earned as we went from six percent to 11 percent. Nevertheless, the ending wealth is increased by a factor of six! Once again, the effects of compounding are not linear or proportional, but exponential.

Insights

This is how investors build wealth over time: steady compounding, adding to savings whenever possible, and reasonable net rates of return (after costs are deducted). The problems come about when people get sidetracked from this steady process. What causes that? To name a few causes, fees and costs, taxes, bad investments, and bear markets.

Specifically, in the case of mutual funds, based on the arguments examined in Part 3, what causes mutual funds to often perform less well than investors were counting on, and to produce less final wealth than expected? The reasons are the same as before.