• Jan De Ost

The compounding-effect

Updated: Nov 15, 2019

#stocks #compounding #longterm

Imagine buying a listed company at around 2£ per share. And three years later, the stock price went up to around 3,4£. That means a total return of 70%, dividends not included.

That sounds impressive! Though as an investor, that is not our whole concern.

"How so?", we hear you think, "Isn't that enough by itself?"

It all depends on how long it took you to get this return. As a comparison:

If the stock price of a company doubles in price over a period of 20 years, it only yielded 3,5% per annum. And that's not really an extraordinary result, is it?

As an investor you can always buy all of the world's stocks combined -called an index- or make your own selection. You could start by eliminating all companies that are loss-making, carry heavy debt loads etc. (NOTE: do not attempt this yourself, unless you are a financial expert.) That should yield potentially higher returns. Yet, the index itself is hard to beat.

The investor who bought the world index of stocks in 2004, here below, (and did nothing else), would have tripled his money (a return of 200%):

That may sound phenomenal, and frankly it is, but it did take a total of 15 years to get this result. That comes down to a 8% return per year. In other words: if we start investing today and yield, on average, 8% per year in the coming 15 years, we will return 200% in total, or triple our money.

That is the magic of compounding!

The compounding effect is indeed astonishing (our link here). It challenges mankind's ingrained linear thinking but is nevertheless a fact and indisputable. We as mankind ought to use this effect to our advantage. Norway has done this for decades, to the enormous benefit to it's population. Their national fund has compounded at around 6% per year and is now worth over 10 trillion Kroner, or 1 trillion €! The world should follow it's example.

The compounding effect requires only 2 ingredients: an annual yield and... time. Combine both and you get a snowball-effect. An estate that grows not only larger, but larger at a faster rate as time rolls by. Because time is rolling forward, we as asset managers use it to our advantage. We think long term.

"But where to get this healthy return?", the reader thinks. "Aren't stocks volatile?" "Isn't their too much uncertainty?" "Aren't stocks downright dangerous?"

If we look back to the graph above, we are inclined to think that the total risk seems limited. Especially if you ponder that in 2008-2009 we faced the greatest financial meltdown in history. And look where we stand today!

Imagine even that during those heady years you assumed that the world wouldn't stop turning and you would have bought some of that index. The yield on those purchases would have come down to 271% or 14% per annum during the last 10 years.

Astonishing indeed...

P.S.: Stocks of course remain very volatile. That means that their value can easily fluctuate with 50% or more. That is why they are considered risky.

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