The Power of Compounding and the Mathematics of Recovery

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Our investment commentaries remain committed to preaching why you should remain invested through all market cycles. You will find the following comments to be no different.

J.P.Morgan Asset Management recently published their annual Guide to the Markets. The slides are full of insightful charts and graphs displaying current economic conditions and market data. The charts shown below remind us of the importance of investing, moreover, the importance of remaining invested:

[click to enlarge]

One can draw a couple conclusions from looking at this information:

  • The chart to the left exemplifies the power of compounding using 6.5% as the average return assumption for stocks. Understanding the power of compounding is simple. After so many intervals, the earnings on your investments begin to accumulate. Those accumulated earnings begin to accumulate more earnings, and so on. The longer the holding period, the more your investment returns compound. The following is a simple example of how compounding works with an initial investment of $10,000 growing at a compounded annual growth rate of 6.5%:
    • After 10 years the investment is worth $18,771; Year 0 to 10 growth of $8,771;
    • After 20 years the investment is worth $35,236; Year 10 to 20 growth of $16,465;
    • After 30 years the investment is worth $66,143, Year 20 to 30 growth of 30,907.
  • From an asset class perspective, this same chart demonstrates equity returns are a far superior way to build and grow your wealth compared to cash and bonds. Although these figures in the chart are forward looking capital market assumptions, actual historic performance has returned comparable results.
  • Finally, the chart to the right tells another sobering story. It highlights the daunting mathematics of recovery. If you were to suffer a 50% loss in the market, you will need to experience a 100% return from the bottom to get back to even. The math is even more severe if you were to suffer that same 50% loss, but were withdrawing money from the portfolio. This exemplifies the importance of remaining invested, especially during these down turns. We believe this because if you were to sell out of the market and miss any part of the recovery, it will be that much harder to get back to even and resume growing your wealth. Additionally, no one knows how severe a correction will be and trying to time the market is pointless. As the old saying goes, “the market can remain irrational far longer than you can remain solvent.”

All of this data and math is predicated on the assumption that the next 30 years will be similar to the last 30 years. Of course, we do not believe that the next 30 years will resemble the past 30 years exactly. We also know as fact that your equity investments will not return 6.5% every year as adopted in the chart above. But we do believe that the end result will be very similar to what has transpired over the last 30 years, and most every 30 year period prior to today.

 

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About the Author:

Thomas J. Greco, CFP®, MBA - Thomas chairs the Investment Committee for Concentus Wealth Advisors. Thomas graduated Bloomsburg University in 2002 with a B.S. in Finance. He also earned his MBA from St. Joseph’s University with a concentration in Finance and holds a CERTIFIED FINANCIAL PLANNER™ designation. His previous experience was with The Vanguard Group and Turner Investment Partners. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®

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