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<\/h3>\n<\/h3>\nFirst, the source of compounding determines the rate of compounding. We all know that to earn the proverbial biscuit, you have to risk it. Casinos take a calculated risk with each spin of the Roulette wheel. Many spins make uncertain outcomes near certain. Similarly, diversified exposure to risk assets in financial markets, given enough time, has shown to pay off with high consistency \u2013 and at a superior compounding rate.<\/p>\n
Second, know your enemy. The anti-matter to compounded returns is compounded costs. A sure way to reduce the exponential benefits of compounding is to tolerate a counter-compounding effect through high fees, costs, and inefficient re-allocations. The sheer impact might surprise you.<\/p>\n
To understand why the source of compounding matters so greatly, we need to first understand the difference between\u00a0Saving<\/strong>\u00a0and\u00a0Investing.<\/strong><\/p>\n We need both \u2013 but only investing truly benefits from compounding.<\/p>\n Why is that?\u00a0<\/strong>The evergreen adage of higher risk, higher reward gives us a clue. Risk\u2019s reward crucially relies on differences in our perception and temporal tolerance of it. Savers and short-term investors have less appetite for risking the seeds they intend consuming tomorrow. They thus pay a premium to investors willing and able to bear the possible short-term pain of sowing seeds for the long-term gain they seek. Harvesting risk premiums to truly compound one\u2019s efforts\u00a0requires time, not timing.<\/strong><\/p>\n But how much does taking some risk truly matter? The answer may surprise you. To show just how important harnessing the right source of compounding is, we use a simple illustration.<\/p>\n Suppose you have two individuals, Saver and Investor. Both studied the same degree and started earning the same salary 20 years ago. Saver worked long hours and occasionally weekends. Saver is all work, no play. And it shows. Saver earns a whopping 12% salary increase every year.<\/p>\n Investor likes to pursue other hobbies, has a great work\/life balance, and works far shorter hours. And it shows. Investor earns a basic 6% salary increase each year in line with inflation.<\/p>\n Both have one thing in common \u2013 they diligently set aside 10% of their income. What they do with their saving contributions differ though. Saver dislikes risk & prefers certainty and earns a fixed 5% annualised return on a savings deposit account. Investor embraces risk and earns the equity market risk-premium over time by investing in the Satrix Top 40 ETF. Suppose we left them to work 22 years and then reviewed their wealth in 2023. Note the below:<\/p>\n At the end of 22 years, the hard-working Saver had a final salary more than 3 times that of Investor. He contributed\u00a0R1.1m<\/strong>\u00a0to his savings pool (dotted light blue line) and reached an accumulated\u00a0R1.62m<\/strong>\u00a0capital (solid light blue line, earning\u00a045.9%<\/strong>\u00a0on total contributions). Investor put aside half this amount (dark blue dotted line) yet grew her total capital by more than\u00a015%\u00a0<\/strong>that of Saver (netting a return on total contributions of\u00a0252%<\/strong>).<\/p>\n By setting aside capital every month, both enjoyed the benefits of compounding. One just did so significantly more than the other. Saver focused on growing income; Investor focused on what she did with hers. And this made a very big difference. It turns out that being intentional about what you do with your earnings matter far more than simply working to grow it. Very few apply this principle in life though; we are mostly conditioned to become income maximisers, not wealth creators.<\/p>\n The lesson is clear, but some might not be convinced. In fact, many would argue that \u201cthis time is different\u201d, or TTID. Considering all the turmoil, currency uncertainty and all that, earning equity market risk premiums today might seem too risky and so choosing safer, less rewarded alternatives seem prudent. But if history has taught us anything, it is that TTID is only right in the short-term and can be the enemy of long-term wealth creation.<\/p>\n Consider that if we were to randomly select a day in the past and invest R1 in the All-Share index since 1995 \u2013 the odds of returning more than 5% annualised are 74%, 82% and 93.9% respectively over 1, 3 and 5 years (this is in line with other global equity indexes too). Similar to the casino relying on multiple spins of the wheel to make uncertain outcomes near certain \u2013 time & patience places the odds firmly in your favour to earn the equity premium.<\/p>\n The second pillar to making compounding work for you is avoiding its archenemy: costs. If we were to take Investor\u2019s success above and apply a cost layer to it \u2013 her nest egg fast erodes. As before, the scale is more surprising than the statement: R1m invested in the Top 40 since 2000 would\u2019ve been worth\u00a0less than half\u00a0<\/strong>if it had an annualized fee of 3.5%. The compounding impact of fees is crystal clear when you see it. Below we show different fee scales and show at the end how much total return were lost accordingly.<\/p>\n We often hear that compounding is the 8th wonder of the world and that it is a powerful force for wealth creation. In this short piece we argue that to truly harness the wealth creating potential of compounding, we need to know what the source is of compounding, and also, what is working against it.<\/p>\n Investors have been well primed on the benefits of compound returns. What is underappreciated, though, is that not all compounding is equal. In this article…<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[4],"tags":[],"class_list":["post-1263","post","type-post","status-publish","format-standard","hentry","category-innov8ions"],"_links":{"self":[{"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/posts\/1263","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/comments?post=1263"}],"version-history":[{"count":1,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/posts\/1263\/revisions"}],"predecessor-version":[{"id":1267,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/posts\/1263\/revisions\/1267"}],"wp:attachment":[{"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/media?parent=1263"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/categories?post=1263"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.innov8fs.co.za\/blog\/wp-json\/wp\/v2\/tags?post=1263"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}\n
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<\/p>\nSecond Pillar: Know Your Enemy<\/h4>\n
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<\/h4>\nConclusion<\/h4>\n
Compounding works best if you harvest well-diversified and fairly rewarded risk premiums (such as those earned in equity markets) while limiting investment costs. Only then will this wonder truly work its magic in your portfolio.<\/h4>\n","protected":false},"excerpt":{"rendered":"