The Magic of Compound Returns

A Look at the Markets - Vanguard FTSE All-World Index

The Vanguard FTSE All-World ETF is only 3.4% down from its all-time highs (ATH) in July, despite the increased volatility in August and again at the start of September.

Notice how the Bollinger Bands (green and red lines) show this increased volatility by moving further apart.

This week, the US Core Price Inflation (CPI) came in at 2.5%, slightly lower than the expected 2.6%. A lower CPI increases the chances that the Federal Reserve will reduce interest rates when it meets next week. Investors are expecting either a 25 basis point (0.25%) or a 50 basis point reduction.

A reduction in interest rates is likely to be positive for asset prices.

The Magic of Compound Returns: Turning Small Investments into Big Wealth

When it comes to investing, one of the most important concepts to understand is compound returns. Albert Einstein reportedly referred to compound interest as the “eighth wonder of the world.” This powerful financial principle allows investors to grow their wealth exponentially over time, making it a key strategy for long-term financial success.

What are Compound Returns?

In simple terms, compound returns refer to the process of earning returns on both the initial investment and the returns previously generated. Instead of withdrawing your profits, you reinvest them, allowing your investment to grow at an increasing rate over time. The longer you stay invested, the more your wealth compounds, creating a snowball effect.

How Compound Returns Work - A Practical Example

Let’s break it down with an example:

Imagine you invest €200 per month in the stock market with an annual return of 10%. For simplicity, let’s just say you invest 2,400€ at the start of the year though in reality, you would probably invest every month. After one year, your total investment would be the 2,400€ initial investments plus 240€ interest giving you a total of €2,640.

At the start of the second year, you invest another 2,400€. What is your return at the end of the second year?

It is not 240€ x 2 = 480€.

• You start the second year with 2,640 + 2400 = 5,040€

• a 10% return would give you an increase of 504€

• Total at the end of the second year is 5,544€

Over time, as you continue to reinvest, the returns you earn increase each year.

The magic comes from extending the time period. Assuming you continue to invest 2,400€ at the beginning of every year:

• After 10 years you will have a total investment of 42,074€

Can you guess how much after 20 years?

• After 20 years you will have a total investment of 151,206€

As you can see, the power of compound returns becomes more significant the longer you stay invested.

When should you start investing?

Time is the most critical factor in maximizing compound returns. The earlier you start investing, the more your money can grow. Even small, regular investments can grow into large sums if you give them enough time to compound.

For example, if you start investing €200 a month at age 35 and continue until you are 65, assuming an average return of 10%, you would have approximately 434,264€. This sounds quite reasonable but let’s see what happens if you start just 10 years earlier.

If you start investing the same amount at age 25, you would have around €1,168,444 by the time you reach 65. The 10-year difference in starting age leads to a massive difference in the final outcome.

This shows why starting early is one of the best strategies for building long-term wealth.

So when should you start investing? As soon as possible!

Are these numbers realistic?

In my opinion yes. Firstly, many people start working by 25 and have a 40-year career. People starting work at 27 may well continue until 67.

The historical average annual return of the S&P 500, including dividends, is approximately 10%. This figure is based on long-term data, typically spanning several decades. However, it's important to note that the actual annual return can vary significantly from year to year due to market volatility.

In some years, the S&P 500 may experience much higher returns, while in other years, it can have negative returns. Over the long term, though, the 10% average is a commonly used benchmark for the index's performance.

Note that past performance is no guarantee of future performance.

Conclusion

The sooner you start thinking about your financial future, the more time you will give yourself to secure a comfortable retirement.

Trump - Harris Debate and Taylor Swift

Did you watch the Trump-Harris TV debate earlier in the week?

Many commentators, even from Trump-supporting Fox News, say that Vice President Harris performed better. However, it’s unclear if this will impact the election result or even change the polls.

An interesting aspect was Harris’s team working with Republicans unhappy with Trump in preparation for the debate. During the debate, she seemed to know how to make Trump lose focus and go off-topic.

It’s unlikely this will affect Trump’s core supporters. However, Harris has seen an increase in donations after her strong performance.

In my view, the real disappointment was what wasn’t discussed. Despite the $35 trillion US national debt, there seemed to be little debate or proposals on how to reduce it. Can it keep rising forever? Only if they continue devaluing the currency, in my opinion.

Shortly after the debate, Taylor Swift publicly supported Kamala Harris and her running mate, Tim Walz. While this may not change how people vote, Swift encouraged new voters to register through a well-written Instagram post. She even signed her message as “Childless Cat Lady,” referencing JD Vance’s comment about Harris.

Idiom of the Day: Snowball Effect

Snowball effect - idiom - a situation in which something increases in size or importance at a faster and faster rate

Imagine a child rolling a snowball down a hill when it gets bigger the further it travels.