The Power of Compounding in Different Investment Strategies: Why More Equity Can Mean Better Returns

Robin Powell Manning and Company

Investing can often seem complex, but one fundamental principle to understand is the power of compounding. Compounding is when the returns you earn on your investments begin to earn returns themselves, snowballing your initial investment into a much larger sum over time.

As nobody knows the future, long-term history can be our only guide. The markets have seen many terrible and wonderful times during the last 50 years. Why 50 years I hear you ask? Well for one, it demonstrates a long term, and the second reason is this period is on the lower side of total investment term for most people. If you invest for your retirement from 20 to 60 and only enjoyed a 10-year retirement, this would be on the low side of total investment term.

Most investors forget that they are not just invested up to retirement, but throughout retirement. How else do you think you have a chance of securing a flexible, accessible and rising income for your golden years?

When comparing different investment strategies, particularly those with varying mixes of equities (owning great businesses) and bonds (lending to great businesses), the impact of compounding becomes especially significant. Let’s break this down in simple terms and see how different asset allocations have historically performed over the long term.

Long-Term Returns: Equities vs. Bonds

Historically, since 1974 to 2023 equities have delivered higher average annual returns compared to bonds. On average (heavy emphasis on the word 'average' i.e. not the same year in and year out), equities have returned about 11.10% per year (including dividends), while bonds have averaged around 8.49% per year. These differences might seem small and inconsequential on the surface, but over decades, they result in vastly different outcomes due to compounding. These figures are general returns because different sites show slightly different figures.

Actually, the figures aren’t that important. What is, is the additional amount that equities have historically grown over and above bonds over the long-term. This is where the compounding over time comes into play.

Comparing Different Portfolio Allocations

Let’s examine how different portfolio allocations might perform over a long investment horizon using the historical averages:?

1. 100% Equities: Assuming a 10% annual return.

2. 90% Equities / 10% Bonds: Blending the returns to reflect the mix.

3. 80% Equities / 20% Bonds: Further balancing risk and return.

4. 70% Equities / 30% Bonds: A more conservative yet still growth-focused approach.

5. 60% Equities / 40% Bonds: A balanced portfolio often recommended for moderate-risk investors.

5. 50% Equities / 40% Bonds: A balanced portfolio often recommended for smack bang middle of the road-risk investors.

To illustrate, let’s consider a ￡10,000 investment over 50 years:

Caveats: These returns highlight the significant impact even a small difference in percentage can make over time when compounded. The sequence of returns, or the order in which returns occur, is a crucial factor in determining the overall growth of an investment. I also apprciate that ￡10,000 in 1974 would have been a fortune. This is purely to demonstrate the difference in returns and what the power of compounding has over this time.

As you can see, the more equities in the portfolio, the higher the potential returns, thanks to the higher average return of equities and the power of compounding.?

The Big Trade-Off - Volatility and Investor Behaviour

However, it's crucial to understand that higher equity exposure also means higher volatility. Equities can be quite volatile and certifiably insane in the short term, with significant ups and downs. This volatility can be stressful and may lead some investors to make poor decisions, such as selling during a market downturn.

A 100% equity portfolio, while offering the highest returns over the long term, will also experience the highest volatility. For instance, during the 2008 financial crisis, the S&P 500 (an index comprising 500 of the most innovative and profitable businesses in the USA) temporarily fell by about 30%. In this instance it got back its temporary losses within 3 months and has since gone onto new highs. Investors with high equity exposure need to be able to stomach such downturns without panic selling.

Balancing Risk and Return?

The key is finding a balance that matches your risk tolerance and investment horizon. Historically, while a 60/40 portfolio may not match the returns of a higher equity allocation, it provides a smoother ride with less volatility, making it easier for investors to stay the course during turbulent times. In essence, more often than not, an exposure to bonds basically lets many clients sleep a little easier at night albeit sacrificing the long-term gains of having more equity exposure.?

For long-term, patient investors who can handle the ride, a higher equity allocation has historically provided better returns. However, for those who prefer less volatility, a balanced portfolio with a mix of equities and bonds may be more appropriate.

Conclusion?

In summary, the historical data clearly shows that the larger the equity content in your portfolio, the better the returns have been for long-term, patient investors who have good investor behaviour. But remember, higher returns come with higher volatility. Understanding your own risk tolerance and investment behaviour is crucial to choosing the right portfolio mix.?

Invest wisely and stay patient, letting the power of compounding work in your favour over time.