Compounding is the continual growth of money based on an ever-expanding sum consisting of the initial principal and the ongoing accumulation of interest. Most of us are familiar with compounding interest, an experience that often begins in childhood as the funds we deposited in our savings account grew slowly over time by just sitting there. Albert Einstein referred to it as the eighth wonder of the world!
However, just as money compounds in a positive way, it can also compound in a negative way, causing damage to your portfolio and teaching you a harsh lesson about protecting your assets from losses. The consequence of losses in your investment portfolio is harmful not only to your bottom line, but also sabotages your effective use of time which then even further diminishes your portfolio’s growth. A wise investor seeks gain on one hand and loss-prevention on the other. This may seem obvious, but human emotions can sabotage your best intentions.
Understanding the effect of negative compounding may result in changing the way you think about investing, accepting risk, planning your investment strategy, your expectations of results, and ultimately the quality of life you can achieve with more diligent reflection and wiser decision-making.
Negative compounding is not a familiar term to most people, yet it is an ever-present danger for investors. Whenever you suffer an investment loss, negative compounding is present. You had $10,000 and you lost $1,000 in an investment that didn’t work out. To return to your break-even point of $10,000 you have to do one of two things: (1) Either consume time at your present rate of return until you have restored the lost $1,000, or (2) increase your risk and invest at a higher rate of return to restore the lost $1,000 and preserve more investing time. Both choices are unappealing because either you lose time that could have been used to further advance your wealth, or you subject your remaining wealth to potential loss through increased risk.
Investment losses are a dreary situation! You’ve suffered the loss of capital, and now you have to lose investment time or subject your investments to increased risk by investing at a higher rate of return to catch up! What’s an investor to do? Don’t suffer losses…which is so much easier said than done.
Here’s the thing: When a portfolio loses 10%, it must now earn 11.1% to return to its breakeven point, not just the original loss of 10%. Here are the figures that prove this point:
Period 1:
Beginning value: $100,000
Return: -10%
Ending value: $90,000
Period 2:
Beginning value: $90,000
Return: +10%
Ending value: $99,000
So, not only does the portfolio need to earn more money to regain the breakeven point, but there is also the loss of the investment time it takes to regain the lost funds. For example, if it takes a year to reach the breakeven point, that’s the loss of a year that could otherwise have advanced the value of the portfolio. If an investor has a 30-year investment time range, the loss of a single year’s progress is equal to the loss of 3% of the available time for building a strong retirement fund. You can see how the loss of investment capital is negatively compounded, both in lost money and in lost time.
Imagine the horror of losing -40% of your portfolio…which happened to some investors during the Great Recession of 2008. If they were able to invest their portfolio with a 7% return, it would take them 7.55 years just to breakeven and regain the lost funds! And if they had a 30-year investment time range, they would also suffer the loss of about -21% of their available investment time!
The important point is that the smart investor limits his or her losses at every opportunity. If your portfolio grows 20% in Year 1, drops -40% in Year 2, grows 50% in Year 3, drops -30% in Year 4, and grows +50% in Year 5…your portfolio has averaged a rate of 10% growth…but a stable portfolio can also achieve a +10% growth rate and gain a much higher appreciation of capital because extreme losses will not diminish the capital base, allowing a steady growth rate rather than a see-saw rate that erodes the capacity of the investment from achieving a higher value.
Therefore, steady growth is a superior investment strategy. Two investments that average 10% are not equal. The one with less volatility is the one achieving greater wealth. One chases rainbows while the other gets the pot of gold.
Negative compounding is dangerous to your portfolio because it reduces both your investment capital and your investment time. A skilled investment manager can generate better-than-market returns, manage tax issues, and help you stay targeted so your portfolio achieves your investment goals. Consider working with a fee-based financial advisor with the training and experience to guide you so you can enjoy the retirement of your dreams.
Joseph M. Maas, CFA, CVA, ABAR, CM&AA, CFP®, ChFC, CLU®, MSFS, CCIM
Synergy Financial Management, LLC
701 Fifth Avenue Suite 3520
Seattle, Washington 98104
ph: 206.386.5455
fx: 206.386-5452