Investing, Investing Basics

The Price of Compounding

by Ross Slaneff Associate Portfolio Manager - BMO Nesbitt Burns

Summary: Understanding Compound Growth

Nothing is free, including investment returns.

Compound growth is a powerful force that we are not designed to intuitively grasp. If I asked you what 8 + 8 + 8 + 8 is, you could answer very quickly. But if I asked what 8 x 8 x 8 x 8 is, your head would explode (it’s 4,096).

Compounding is hard for us to understand because the cumulative effects of growth on growth over long periods of time add up to outrageously large numbers. If you invest $1,000 per month for 30 years your total capital deployed will be $360,000. At 9% investment returns, the total value of your investment will grow to about $1.7 million. Not bad, but it gets better.

The magic of compounding is back end loaded in a big way. Keep investing $1,000 per month for another 5 years, just $60,000 additional capital, and your investment will grow to over $2.7 million. Add 5 more years, making 40 years and $480,000 of contributions, and your investments are now worth over $4.2 million!

Of course, to earn investment returns anywhere near 9% will require a substantial equity allocation, likely 80%-90%+. This brings us to the price of compounding. There are fund fees and advisor fees, we are all aware of those. But the real price to successful investing and compound growth is fear, uncertainty, and volatility.

Investing in the stock market brings with it a fair amount of volatility. Your $360,000 will not grow to $1.7 million in a straight line, there will be many 10% declines and even 20% and 30% bear markets.

Presented with this reality, you have three options: 1) pay the price and stay invested in high quality public equities, likely hiring an investment advisor to guide you along the way, 2) refuse to pay the price, which is just trading the uncertainty of investment returns today for uncertainty of your financial security and cash flows in retirement, or 3) chase some new investment fad or financial alchemy that promises you equity returns for bond-like volatility.

Many choose Option 2, particularly in today’s era of 5% GIC rates. There is certainly a place for GICs but do not confuse a GIC with investing. GICs are well suited for liability matching (i.e. you have a known expense inside the next 1 to 5 years and need certainty of outcome). Outside of that, a GIC is not truly risk-free. Rates are 5% now but when your 5-year GIC matures you will be exposed to reinvestment risk and interest rates could be much lower. And if you hold that GIC in a taxable account, all of the interest is fully taxable as income, making GICs much less tax efficient than stocks.

As for Option 3, the financial industry is happy to sell you all sorts of structured products, whole life insurance, private funds, etc. But there is no free lunch. Any product sold to you can either provide less volatility or higher returns, not both. The more layers between you and the underlying investment, the more embedded fees. There are only so many things to invest in: cash, bonds, stocks, real estate, and commodities. If you aren’t being sold one of these things directly, then you are being sold a packaged or derivative solution.

Financial products in Option 3 tend to be illiquid, have high fees, or both. The other telling thing about financial products is how flavour of the month they are. These days an investment advisor can’t go a single day without being pitched on structured notes and private credit funds, in years past it was venture capital and private equity that was all the rage. If the same salesperson is pitching different product every year, maybe they don’t have your best interests at heart?

The rational and disciplined young professional should choose Option 1, stay invested in high quality equities and let your superpower, a long time horizon, work its magic. Establish a savings plan, automate it, and ignore the noise and fearmongering. Remember, news organizations are all about headlines, not history. History is on the side of the optimists.

One of my favourite investors and fund managers explained the price of equity investing and compounding this way: “Compounding does not, and cannot, happen over the course of a year or two or even five. Compounding requires decades. Rough markets and share price declines do not have to be enjoyed. But to compound, they must be endured.”

Opinions are those of the author and may not reflect those of BMO Nesbitt Burns Inc. ("BMO NBI"). The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. BMO Nesbitt Burns Inc. is a wholly-owned subsidiary of Bank of Montreal. BMO Nesbitt Burns Inc. is a Member - Canadian Investor Protection Fund. Member of the Investment Industry Regulatory Organization of Canada.

Ross Slaneff
About Ross Slaneff

Ross Slaneff, CFA is an Associate Portfolio Manager with BMO Nesbitt Burns in Calgary, Alberta. He is passionate about helping his clients build and preserve wealth. If you would like to discuss this article with Ross, connect with him on LinkedIn.

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