Why bother Investing? The Power of Compounding

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THIS BLOG IS ESPECIALLY IMPORTANT FOR YOUNGER READERS
I fancy working on an easy Blog after a few recent ones on Stocks where I have had to use my Brain - I am in full Summer Mode now and there are plenty of more interesting things going on than the Stockmarket and all its accoutrements.

A while back someone asked me to do a Blog on how much Money you might need to give up Work. I have been thinking about how to write this one and got distracted quite a bit, but I reckon I have the shape in my mind now. However, in order to write that Blog, I need to write this one first - i.e, I am still ducking the Request !!

What I want to do here is to take an Example Amount of Cash and use the Power of Compounding over the Years to show how Money can grow at various different Annual Percentage Growth Rates. In combination with this I will address what are Realistic Returns - and this ties back to an earlier WheelieBlog I did called the ‘Rule of 72’ which you can read here:

http://wheeliedealer.weebly.com/blog/the-rule-of-72-and-its-implications-on-our-expectations

OK, let’s get started.

The Maths
I will take an Example Amount of Cash and multiply it by a Percentage Annual Return. I will then take the Result of this Calculation and multiply that by the same Percentage Annual Return, and then I will take that Result and multiply it again by the same Percentage Annual Return, etc. etc.

By doing this sequence, it should show how the Starting amount of Cash grows over time according to the CAGR - Compound Annual % Growth Rate.

The Parameters of the Calculations
I will start with a Sum of £10,000 - this is pretty much an arbitrary figure but it should be an amount that people can relate to. I understand these numbers are Commutative - so if you have £100,000 as your Starting Point, then you just add a ‘0’ onto the numbers (i.e. multiply by 10). If your Starting Point is £40,000, then just multiply by 4. If your Starting Point is £5000, then halve the numbers - you get the point.

The Annual Growth Percentages I will use are as follows:

• 3% - this would be a very good Return on Cash at the moment.
  
• 5% - nice round number.
  
• 7% - Real Returns (after Inflation) for the Stockmarket over many years are around this kind of number. In theory, you could get this from Index Tracker Funds - however, with Costs and suchlike I doubt this would be easy.
  
• 10% - This is the kind of Return I aim for on the Exposure Value of my Portfolio. I am sure many Great Investors and Traders achieve more than this - but it takes effort and I am happy to have an easy life and not trade all that often.
  
• 12% - A bit of Safe Leverage on a Portfolio should make possible this kind of Return - but it is far from easy.
  
• 15% - this is an extremely good Return - few people can achieve this.
  
• 20% - an Exceptional Rate of Return - Buffett probably only just gets near. Robbie Burns does better than this but he is extremely unusual.
  

Please note, I am totally ignoring Inflation for ease and simplicity. There may also be some very slight Rounding Errors - I have tended to Round Down in the Tables.

Tax is not included and the Growth Percentages chosen include Dividends - i.e. when I say 7% Growth, part of that is achieved from Dividend payments. It therefore follows that if you buy Stocks without Dividends then you are setting yourself behind from the start - you better be confident of your expectations of fast Capital Growth.

In all the Examples I will go for 30 years - seems a sensible number to choose. If you want more, you can add them on, if you want less, you can lob a few off !! The figures are for the End of each Year.


3% Annual Growth

---

Year 0   £10,000
Year 1   £10,300
Year 2   £10,609
Year 3   £10,927
Year 4   £11,254
Year 5   £11,591
Year 6   £11,938
Year 7   £12,296
Year 8   £12,664
Year 9   £13,043
Year 10  £13,434

Year 11  £13,837
Year 12  £14,252
Year 13  £14,679
Year 14  £15,119
Year 15  £15,572
Year 16  £16,039
Year 17  £16,520
Year 18  £17,015
Year 19  £17,525
Year 20  £18,050

Year 21  £18,591
Year 22  £19,148
Year 23  £19,722
Year 24  £20,313
Year 25  £20,922
Year 26  £21,549
Year 27  £22,195
Year 28  £22,860
Year 29  £23,545
Year 30  £24,251

---

5% Annual Growth

---

Year 0   £10,000
Year 1   £10,500
Year 2   £11,025
Year 3   £11,576
Year 4   £12,154
Year 5   £12,761
Year 6   £13,399
Year 7   £14,068
Year 8   £14,771
Year 9   £15,509
Year 10  £16,284

Year 11  £17,098
Year 12  £17,952
Year 13  £18,849
Year 14  £19,791
Year 15  £20,780
Year 16  £21,819
Year 17  £22,909
Year 18  £24,054
Year 19  £25,256
Year 20  £26,518

Year 21  £27,843
Year 22  £29,235
Year 23  £30,696
Year 24  £32,230
Year 25  £33,841
Year 26  £35,533
Year 27  £37,309
Year 28  £39,174
Year 29  £41,132
Year 30  £43,188

---

Big number that isn’t it? Bet you didn’t expect it to be so much bigger than the result for 3%. Note that just 2% difference has such an impact when Returns are Compounded over 30 years - and consider what this means if you have Costs of 2% a year………

7% Annual Growth

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Year 0   £10,000
Year 1   £10,700
Year 2   £11,449
Year 3   £12,250
Year 4   £13,107
Year 5   £14,024
Year 6   £15,005
Year 7   £16,055
Year 8   £17,178
Year 9   £18,380
Year 10  £19,666

Year 11  £21,042
Year 12  £22,514
Year 13  £24,089
Year 14  £25,775
Year 15  £27,579
Year 16  £29,509
Year 17  £31,574
Year 18  £33,784
Year 19  £36,148
Year 20  £38,678

Year 21  £41,385
Year 22  £44,281
Year 23  £47,380
Year 24  £50,696
Year 25  £54,244
Year 26  £58,041
Year 27  £62,103
Year 28  £66,450
Year 29  £71,101
Year 30  £76,078

---

Note in a similar way to the previous example, that just a couple of % from 5% to 7% makes a huge difference to the Overall Return after 30 years - almost doubling it.

10% Annual Growth

---

Year 0   £10,000
Year 1   £11,000
Year 2   £12,100
Year 3   £13,310
Year 4   £14,641
Year 5   £16,105
Year 6   £17,715
Year 7   £19,486
Year 8   £21,434
Year 9   £23,577
Year 10  £25,934

Year 11  £28,527
Year 12  £31,379
Year 13  £34,516
Year 14  £37,967
Year 15  £41,763
Year 16  £45,939
Year 17  £50,532
Year 18  £55,585
Year 19  £61,143
Year 20  £67,257

Year 21  £73,982
Year 22  £81,380
Year 23  £89,518
Year 24  £98,469
Year 25  £108,315
Year 26  £119,146
Year 27  £131,060
Year 28  £144,166
Year 29  £158,582
Year 30  £174,440

---

Wow, the jump there is amazing - just 3% more (ok, in reality that is a lot !!) and the Final Figure is way over Double.

12% Annual Growth

---

Year 0   £10,000
Year 1   £11,200
Year 2   £12,544
Year 3   £14,049
Year 4   £15,734
Year 5   £17,622
Year 6   £19,736
Year 7   £22,104
Year 8   £24,756
Year 9   £27,726
Year 10  £31,053

Year 11  £34,779
Year 12  £38,952
Year 13  £43,626
Year 14  £48,861
Year 15  £54,724
Year 16  £61,290
Year 17  £68,644
Year 18  £76,881
Year 19  £86,106
Year 20  £96,438

Year 21  £108,010
Year 22  £120,971
Year 23  £135,487
Year 24  £151,745
Year 25  £169,954
Year 26  £190,348
Year 27  £213,189
Year 28  £238,771
Year 29  £267,423
Year 30  £299,513

---

Now those numbers are astonishing - £10,000 turned into £300,000. 12% is difficult to achieve, especially in the early years whilst you are learning, but it is not impossible with some Leverage. I am quite shocked by the outcome. The higher Percentages to come are more for fun really (few people will be able to achieve this) - the numbers will be bonkers……

15% Annual Growth

---

Year 0   £10,000
Year 1   £11,500
Year 2   £13,225
Year 3   £15,208
Year 4   £17,489
Year 5   £20,112
Year 6   £23,128
Year 7   £26,597
Year 8   £30,586
Year 9   £35,173
Year 10  £40,448

Year 11  £46,515
Year 12  £53,492
Year 13  £61,515
Year 14  £70,742
Year 15  £81,353
Year 16  £93,555
Year 17  £107,588
Year 18  £123,726
Year 19  £142,284
Year 20  £163,626

Year 21  £188,169
Year 22  £216,394
Year 23  £248,853
Year 24  £286,180
Year 25  £329,107
Year 26  £378,473
Year 27  £435,243
Year 28  £500,529
Year 29  £575,608
Year 30  £661,949

---

Well, I said it would be a big number. That is meaty. 20% will be insane.

20% Annual Growth

---

Year 0   £10,000
Year 1   £12,000
Year 2   £14,400
Year 3   £17,280
Year 4   £20,736
Year 5   £24,833
Year 6   £29,799
Year 7   £35,758
Year 8   £42,909
Year 9   £51,490
Year 10  £61,788

Year 11  £74,145
Year 12  £88,974
Year 13  £106,768
Year 14  £128,121
Year 15  £153,745
Year 16  £184,494
Year 17  £221,392
Year 18  £265,670
Year 19  £318,804
Year 20  £382,564

Year 21  £459,076
Year 22  £550,891
Year 23  £661,069
Year 24  £793,282
Year 25  £951,938
Year 26  £1,142,325
Year 27  £1,370,790
Year 28  £1,644,948
Year 29  £1,973,937
Year 30  £2,368,724

---

Now that is a huge number !! You can see why Warren Buffett is so loaded.

Tax
Note that all of these Calculations have no allowance for Tax. You may object that this is unrealistic (or even immoral - if you believe that Governments spend your money well), but I think it is very justified to excluded Tax on the basis that £10,000 is well below the current ISA Limit for one year and leaving your Money to grow in such a Tax Avoidance (Legal) Wrapper is just good sense.

However, there is of course a Huge Risk that future Governments could change the ISA rules and there is talk that a Limit of £1m could be put on the Value of Money you can have in an ISA - I guess the theory is that they would tax anything above the Limit. On a Long Term Horizon, such as 20 to 30 years, this has to be very likely to happen and could hit the Returns in the Tables above.

Already the current Government has reduced the Lifetime Limit on SIPPs (Self Invested Personal Pensions) to £1.25m. However, with careful use of SIPPs, ISAs, Spreadbets, Capital Gains Tax Allowance and Personal Income Tax Allowances, I am sure many Tax implications can be reduced.

Portfolio Management Costs
I just want to reiterate something I mentioned in passing between a couple of the Tables above.

It should be clear to you that just a couple of % changes from one Table to another have a massive difference on the Final Returns created. This clearly shows that it is vitally important to minimise your Costs of running your Portfolio. This means keeping Platform Costs as small as possible and the same with Dealing Fees and Buy/Sell Spreads where possible. You should also think of the Costs of tools such as Magazines, Tipping Websites, Software for Trading etc. etc. - all these are Real Costs and should be minimised as much as you can. If you are not getting Value and Use from a particular Magazine for instance, cancel your Subscription.

As an example, let’s say you have a Portfolio worth £100,000 and you expect to invest for another 20 Years and you are a pretty shrewd Investor and expect to achieve a 10% Return. In this case, if you can save 1% on Costs in Year 1 - i.e. £1000, over the 20 years this is £6725 Extra Return. (I worked this out by knocking a Zero off the £10,000 Starting Figure and Dividing the 20 Year figure by 10). Obviously such savings in the following Years will boost Returns considerably rather than eating away at your gains.

Think about it this way. If you have £100 of Unnecessary Cost in Year 1 and you are achieving 12% Returns per year on Average, then this will add up to £2995 over 30 Years !!!! (I worked this out by lobbing off 2 Zeros from the £10,000 Starting Figure and lobbing 2 Zeros off the 30 Years Finishing Figure from the 12% Table.)

In fact, you can apply this logic to your Wider Spending of normal life - every £100 you p*ss away on Lager could really be costing you £2995 !!

This is why it is critical to control every aspect of your Spending and to realise that if you can just save a Few Hundred Pounds more per year, it has a massive impact over time. I appreciate that if you are an Old Git like me it has less impact, but for anyone below 30 these Numbers are immense. Mind you, even for an Old Bug*er, £100 over 10 years at 12% could be costing £310.

All that money people have wasted on Lottery Tickets over the years……..what a con that is. Taxing the Dreamers…….I have never done the Lottery (I find it pretty distasteful) and I like to think that I have WON Thousands and Thousands of Quids by not wasting my Money on it. In addition, I have then gone on to Invest that Money I did not waste by Investing it at good Rates of Return.

Apologies to any Readers I have offended - but maybe I will have got you thinking about analysing what you spend. We all just let Money fritter through our Fingers and this has a Huge Cost over time.

You Must Avoid Mistakes
If you have read my ‘Rule of 72’ Blog and my Comments throughout this Blog, you should see the importance of having Realistic Expectations of what you can achieve and how vital it is to ensure you are not taking Avoidable Risks. I think it is realistic for an Individual Committed Long Term Investor to aim for 10% CAGR (Compound Average Growth Rate) per year but it is very hard to achieve this in practice.

It sounds easy, and many Readers will have done much better than this over many years recently (I know many have from various discussions) but most of us underestimate the damaging effects of the Odd Bad Years. If you have been steadily achieving 10% CAGR for say 6 years, and then you get hit 30% in a Horrible Bear Market, you will then be massively behind the Game. One Horrific Year can have terrible consequences. For this reason, it is better to not be Greedy and to aim for Steady, Tortoise Like Returns over many years and to avoid the Really Big Pullbacks - this is all about Risk Management and avoiding High Risk Gambles.

I have written extensively about Risks and suchlike - you can find Lots of Blogs on the Subject (the Position Sizing ones are pretty good here) and bits of my Website like the ‘WheelieBin’ and ‘M3 Manifesto’ can help you avoid the Duffers that will drag down your Results.

IT IS BETTER TO FOCUS ON AVOIDING DOWNSIDE RISKS THAN TO TRY TO PICK BIG WINNERS ALL THE TIME.

This is even more vital for Younger Readers - i.e. in your 20s, 30s., although it is still Important for all of us. I know that I would be considerably Wealthier now if I had not lost lots of money in my early years as an Investor. I was a bit Unlucky because I started Investing right at the Top of the Dotcom Boom - I don’t think this was necessarily Greed and stuff although that probably played a part. It was more that I happened to have a pile of Cash and needed to do something with it.

The consequence was that I lost something like 40% of my Portfolio in a few years and it is obvious from the Tables above how much this hurt me. Luckily I had the good sense (probably pure luck really) to diversify with some Bonds and Cash etc. but it set me back many many years. 

The only thing I got right was that I did not give up and I made big efforts to learn what I was doing !!

IT IS CRITICAL TO REALISE THAT YOU MUST AVOID MISTAKES IN YOUR EARLY YEARS AS THEY HAVE SUCH A HUGE IMPACT LATER.

Of course, this is hard to do as, by definition, in your Early Years you are younger and less experienced, and therefore more prone to Screw Ups. You must use Resources like the WheelieDealer Website and other stuff from Experienced Investors to Short-cut your way to avoiding mistakes. Obviously reading Robbie Burn’s Naked Trader book is essential.

I wish the WheelieDealer Website had existed when I started out (Anyone for Time Travel?)

Benchmarking
There has been some recent discussion on Twitter about Benchmarks and it has pretty much followed the usual well-trodden path of selecting an Index to Benchmark your Performance against and the Ins and Outs of this. As you would expect, I have a slightly different slant on this issue.

In many ways I find this Benchmarking by Index probably not all that helpful (or necessarily healthy for an Investor’s state of mind).

Rather than using a Benchmark constructed from an Index or a hybrid version based on a couple of Indexes, maybe it would be better to make your Benchmark one of the Tables above. For example, you could decide that you want to achieve 12% CAGR year in year out and you would use this kind of Table to track your performance against. You would need to decide your Starting Cash and any Cash you add in over the years would need to be added into your ‘Benchmark’ Table calculations.

In many ways, this is more what I do in practice - for me, the problem with Benchmarking against an Index is that firstly I hold Stocks of all sorts of Market Cap sizes and from various Indexes and secondly that the Weightings I use are completely different to those that make up any Indexes - so how meaningful is it really to Benchmark against an Index? To add colour to this, consider the Nasdaq - something like 14% or so of the Index is Apple (AAPL) - how many people have 14% of their Portfolio in Apple? Would it be wise to do so anyway? Very few Indexes are Equal Weighted to the Constituent Stocks and they will not be the same as the Weightings in your Portfolio. It really is questionable how useful such Benchmarks are.

OK, there is a fair argument to say, well, if you can’t beat 7% CAGR each year (which is pretty much what the FTSE100 would probably give you if you bought a low cost Tracker Fund), then what is the point of investing in individual Stocks?

However, this perfectly logical point misses an important element for me - I actually ENJOY my Investing activities and just owning a Tracker Fund would be utterly unfulfilling for me from a Personal Achievement point of view (I guess it’s something to do with the ‘Self Actualising’ bit of Maslow’s ‘Hierarchy of Needs’ !!)

I am of the view that I enjoy my Investing and the Money that flows from it is a secondary thing - and I suggest that this applies to anything in life. If you are enjoying it and passionate about it, you will probably make Money from doing it.

By Benchmarking against an Index that is made up of strange weightings and that is an approximation at best of your Portfolio, you might be setting yourself up to fail. Just as you could probably have a run of good luck and beat your synthesised and imperfect Benchmark, you could just as easily under perform it for unavoidable reasons (that are beyond your control) and this might really knock your confidence as an Investor - never a good situation as you need to be Calm and Rational and not affected by avoidable anxieties.

As ever, it is up to you as an individual to decide what you are happiest with - but maybe the idea of a Benchmark based on a CAGR % Table might be more useful.

How to use these Tables
The point of these Tables is to show clearly how Compounding Returns over many years can grow your Wealth, and how it is vital to avoid unnecessary Tax and Costs.

In addition, these kind of Tables are a huge help in determining when you can give up Work (or reduce the amount of Work you do and go Part Time) and how much you need to Invest to achieve your Retirement Goals.

You could also use these Tables for other Assets apart from Stocks. For instance, you might have a Buy to Let Property and you could create a similar Table to work out how your Wealth could grow from this Asset. I think Property can give very good returns but it is a lot of hassle and has a lot of hidden costs that can eat away at returns. This Blog no doubt should have highlighted the impact of Costs over time.

These are the kind of Steps you can take using the Tables:

• The first thing to do is to decide how many Years you want to work for - for example, if you expect to work another 15 years, then Years 0 to 15 of the Tables are relevant to you.
  
• Next, you need to decide on a Rate of Return that you think you can realistically achieve. If you are an experienced Old Hand, then probably 10% is sensible and if you are particularly sharp, then 12% may apply. If you are new to the game and quite young, then maybe 7% is more applicable - remember, these numbers are for formulating a Rough Plan, if you happen to outperform, then that is Icing on the Gateau.
  
• Then determine your Starting Point. If you have £50,000, then you can multiply all the numbers by 5 - remember, these things are Commutative (I love using that word - I was taught it in Maths at Junior School and have never ever had need to use it since - so now, 39 years on Dear Reader, I am ramming it down your throat !!)
  
• Just these few Parameters from above will give you an idea of the Total Return after your Time Period until Retirement. However, you can get much more sophisticated by adding Money into the Fund each year if you think you will be saving more. For instance, you might Start with £10,000 and then add in £1000 each year after - this will take some Maths and a Calculator, but you should be able to work it out.
  
• Remember, these numbers do not include Inflation - and it is guesswork anyway. A good way to handle the Inflation Element, might be to drop down the Rate of Return Tables a bit. For Example, if you expect to do 12% a Year, then you could drop down to 10% as the 2% Difference might be a fair Proxy for Inflation (I believe that the true Average Long Term Inflation Rate is about 3% - so you may need to go a bit lower.)
  
• If you find that the Final Number you get is Lower than you wanted, then you will need to consider Working more Years, Finding more Money, or maybe how you can achieve a Higher Rate of Return - none of these are easy Options.
  

Anyway, I think that just about covers it. Have fun creating your Tables !!

Kali bradi, wd