A very good video on The Power of Compounding - the 8th Wonder of the World
Showing posts with label compounding at 7%. Show all posts
Showing posts with label compounding at 7%. Show all posts
Friday, 29 June 2012
Friday, 14 October 2011
The difference between Simple Average Returns and Compound Returns
Below is an illustration of the difference between simple average returns and compound returns, as well as the impact of losses no matter when they occur. Each Manager (A through F) had a different investment approach and therefore, performed differently in each of the three years. The table represents the different returns year-after-year over a three-year period for six separate managers.
Client A | Client B | Client C | Client D | Client E | Client F | |
Year 1 | 10.0% | 6.0% | 16.0% | 30.0% | 45.0% | 55.0% |
Year 2 | 10.0% | 10.0% | 10.0% | -20.0% | -30.0% | -35.0% |
Year 3 | 10.0% | 14.0% | 4.0% | 20.0% | 15.0% | 10.0% |
Simple Average | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% |
Compound Returns | 10.00% | 9.95% | 9.89% | 7.66% | 5.29% | 3.49% |
Ending Value of $1 Million Invested | $1,331,000 | $1,329,240 | $1,327,040 | $1,248,000 | $1,167,250 | $1,108,250 |
In each case, the simple return over the three years is 10%, whereas the compounded return (the amount of gain you have realized) fluctuates between a high of 10% and a dismal 3.49%. Despite the larger returns in some years, the investment is more severely impacted by the loss. Interestingly, as the size of the loss increases, a greater percentage gain is required to restore the account back to breakeven. In short, it is important to understand that managers can brag about simple averages but you can only spend compound returns. Our goal is to execute investment strategies that capture the most of bull markets while preserving gains in bear markets to provide superior long-term compound returns.
*While our rule of thumb for investing is "don't lose money", investments have the potential for negative returns over both the short and long term. Our goal, however, is to limit the downside through security selection, asset allocation, diversification, and the use of active risk management, including the use of options and contra-funds.
Compound returns are a reference to the cumulative impact of gains or losses on your portfolio, they are a reflection of your ability in your investing and they are indications of how much money is in your account. Simple returns, on the other hand, are the returns that occur each day, month or year and are only a snapshot look at an investment's performance without regard to its history.
For example, if a portfolio is down 10% one year and up 10% the next, the simple return on this portfolio is 0% and the manager can report a "break-even" performance over these two years if he refers to his simple returns. However, when it comes to compound returns, which reflect the net effect to your account, the portfolio is actually down 1%. The loss in year one reduced the amount of capital invested for the following year and therefore, a higher performance was needed simply to return the investment to breakeven. It would take an 11% gain to make up for a 10% loss, regardless of the order of the gain/loss.
Monday, 12 April 2010
The Amazing 7% Annual Growth Rate
Granted, making the first million dollar is the most difficult. I shan't dwell into this. But for those who already have this $1 million, they should learn all about the amazing maths behind growing this amount at 7% per year.
What does growing at 7% per year look like? It means doubling your money every 10 years. Therefore, if you have $1 invested today, this $1 will grow thus:
00 year - 2010 $1
10 year - 2020 $2
20 year - 2030 $4
30 year - 2040 $8
40 year - 2050 $16
50 year - 2060 $32
60 year - 2070 $64
Study these numbers carefully. Note the incremental amount of money grown in each of these 10 years period below:
00 year - 2010 $-
10 year - 2020 +$1
20 year - 2030 +$2
30 year - 2040 +$4
40 year - 2050 +$8
50 year - 2060 +$16
60 year - 2070 +$32
In particular, note that the incremental growth for each of the latest 10 year period, exceeds ALL the growth of the preceding years. Therefore, the incremental growth of the 10 years from 2060 to 2070 exceeds ALL the growth of the previous 50 years from 2010 to 2060.
Herein lies the power and magic of compounding. Understanding this is very important to grow your wealth. Starting early in your investing is extremely important. Not losing money is important as a moderate growth rate in the absence of losses will translate to a large gain over many years.
Warren Buffett has been investing since his teenage years. Now approaching his 80s soon, he has been investing for the last 60 years. It is not surprising that he is one of the richest man in the world as he has been able to compound his money at phenomenal rates for so many years. What is perhaps worth mentioning is that everytime his wealth doubles over a given period, the incremental wealth for that period exceeds ALL the sum of the incremental wealth for all his previous investing periods.
Now that you have your first $1 million, go forth and multiply. You need not aim for too high a growth. A modest 7% annual growth rate over many years can transform this figure into a large number. Of course, you may be able to do better than this. You will also be amazed by the numbers that come with an additional 1 or 2% additional growth per year.
Do not make mistakes. Luck should play little part in your investing. Investing is fun. It is safe.
Ref:
The Rule of 72
The magic of exponential growth. What does growing at 7% per year mean to you?
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