For investors who want to accelerate returns quickly, compounding interest and alpha could be the kick they need, write JD de Lange and Sam Benjamin.
Albert Einstein is often quoted as saying “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
The beauty of compounding is that while the investment growth starts slowly, it soon accelerates because you are earning growth on ever increasing amounts. Successful investing maximises return for a given level of risk, but compounding alpha will amplify the growth over time.
Making compounding work for you
Invest in an active approach that has the proven history of generating alpha or out-performance.
Put time on your side. The longer your money can work for you, the better compounding works.
Be emotionally disciplined to weather the market fluctuations and if you find this difficult on your own, get advice.
Maximise the benefit
Even if shorter-term history is less convincing – according to the ‘Triumph of the Optimists’, written by Dimons, Marsh & Staunton and tracking the long-term performance of asset classes on a global and regional basis – the asset class that has most reliably generated real growth and outperformed inflation over the long term is equities.
While passive investing (investing in an index that tracks or follows the market) may be a low cost alternative for investors, they could miss out on the benefits offered by alpha generation, and the subsequent compounding of that alpha.
Active managers
With the possibility of lower real returns than in the past, future out-performance of the market (or alpha) of as little as 1 per cent to 3 per cent may become a major factor in helping investors achieve long-term retirement goals. In spite of this, passive investments are becoming increasingly popular.
This popularity is largely based on the notion that a passive approach produces better performance net of fees. But before embracing this broad assertion, investors should consider the opportunity cost of foregoing alpha completely – and that not all active managers are the same.
Opportunity cost
As is often publicised, we know the impact that fees can make on a 30-year investment.
However, one must also consider the cost of missing even a moderate alpha of, say, 2 per cent per annum. As shown in Chart 1, the difference on $10,000 invested for 30 years at an 8 per cent return compounded annually versus a 10 per cent return is $73,867.
Not all active managers are the same
When the debate about active versus passive management is publicised, comparisons that give credence to popular headlines tend to group all active managers together. It is worth noting that ‘active’ managers are not one homogenous group.
Many large ‘active’ managers are quasi index trackers but still charge higher fees for their ‘active’ approach. Proven stock pickers that don’t start with or follow their benchmark index are less common, and very different.
Time is critical
The longer you have to compound potential returns, the better off you will be. This means it is a good idea to start investing as early as possible with those equity managers that are true active managers and can add value.
It is crucial that the manager you choose has the discipline and long-term approach required to help you achieve your goals.
Too often investors chop and change their investment manager based on emotional responses to short-term market performance, which can undermine their long-term results. Maintain the discipline to weather the inevitable volatility of the market. If you can’t do this on your own, seek professional advice.
JD de Lange is the director and Sam Benjamin the relationship manager at Allan Gray Australia.
