Author: Don Stammer, columnist, The Australian.

We often hear how important it is for investors to take a long-term view, particularly when planning for superannuation and retirement. Alas, most investment decisions are decidedly short-term in nature — and never more than in 2019.

A new year will soon be with us. Is the present a good time for investors to clean their slates and refresh their thinking on the longer-term opportunities and challenges in investing? If so, the best starting point is with the magic of compounding.

Compounding occurs when investors choose to reinvest much, or all of the cash earnings generated by their investment portfolios, and to allow capital gains to accumulate. Compounding increases the size of the investor’s portfolio and it enables the annual return on the portfolio to grow.

It’s not just fixed interest securities that generate the power of compounding; indeed, quality shares and good property generally provide compounding of a higher order.

Many thousands of the “compound interest” reports you can read claim Albert Einstein was a great fan of compound interest. He’s said to have described compound interest as “the eighth wonder of the world”, “the most powerful force in the universe”, and “the greatest invention of the twentieth century”.

Perhaps the Einstein quote that stands out is:

“Those who understand compound interest, earn it; those who don’t, pay it”.

Here’s a simple example of the power of compounding. Let’s say you invest $10,000 in shares and expect the long-run return (from dividends plus capital growth) to average 8 per cent a year. (Though obviously in calendar 2019 the results were a whole lot better than that.)

Further, let’s ignore taxation and imputation to simplify.

If the annual dividend is always reinvested in and capital gains are allowed to accumulate, the investment of $10,000 would be worth $21,590, $46,600 and $470,000 respectively after 10, 20 and 50 years; and the annual return, initially $80, would grow to $170 to $375 and to $3750.

Benefits of compounding

Compounding speeds up and strengthens the process of wealth accumulation — indeed, it’s a way in which a patient investor can tap into exponential growth in both assets held and in terms of annual return. Compounding is stronger the longer the investments are held and the higher the annual average rate of return fed into the calculation.

Superannuation arrangements in Australia increasingly take the form of “defined contributions” (where the benefits an individual can derive from super are related to how much the individual can build up in his or her super account), rather than “defined benefits” (where the employer is contracted to pay a pension at prearranged levels). For anyone in their teens, twenties and thirties, the message is particularly clear: holding a significant portion of quality growth assets in your superannuation fund will allow your super to build up faster and further than it otherwise would. Alas, many younger workers choose instead to go mainly with “balanced funds” or “conservative funds” because those names sound “less dangerous”.

We occasionally hear how the power of compounding — in combination with an effective selection of growth assets — has put some people well along the road to becoming rich. An investor who spent $US1000 to buy 52 shares in Berkshire Hathaway in 1964, when Warren Buffett was getting to be widely noticed, and kept them, now has a holding worth $US17.2m (again, we’ve ignored taxes). Or, if you bought $1000 worth of shares in 1960, when Westfield listed on the Sydney stock exchange, and reinvested all distributions (again, we ignore taxes), you’d have made a fortune of $400m by the time the company was sold and de-listed a couple of years ago.

Of course, on the flip side, compounding can seriously hurt people who borrow, particularly those with big debts and who pay high rates of interest (say because they’ve trapped themselves on the treadmill of borrowing via credit cards).

Today’s near-negligible interest rates (and even negative interest rates in the eurozone and Japan) dampen or deny the contribution that interest-bearing investments can make to compounding.

Many people like to learn from their own experience. The trouble with compounding is that, by the time most people see it work its magic on their own portfolio, it’s too late to derive the full benefits.

There’s also the tough question of what rates of return from each of the main asset classes should be used when estimating the future benefits of compounding. Should we use history as a guide, and factor in average returns from the last 10, 20 or 50 years? Or should we allow for the returns from some or all asset classes to differ from what they’ve been? This column will come back to these important questions in the new year.

Here’s a preview of future annual rates of return I’ll be suggesting (the numbers in brackets are the average returns over the last 50 years). Shares: to return 9 per cent a year (10.5 per cent). Bonds: to average 4 per cent (8 per cent). And cash: 3 per cent (7.4 per cent).

The exponential gains from compounding that long-term investors in Berkshire Hathaway and Westfield (and I would add our own ASX-listed CSL) have enjoyed are impressive — and good wishes to all involved. But how do we pick those sorts of opportunities early in the piece? The answer is it’s extremely difficult — not the least because some long-venerated growth companies (remember when General Electric was the world’s most respected company) can fall from grace.

Don Stammer is an adviser to Stanford Brown Financial Advisers. The views expressed are his alone.

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