The Super Fund Co. Blog

The power of compound interest is something we all learned about at school, and it’s something that intuitively makes sense – the earlier you invest money and the longer you can keep it there, the higher the return. The magic of compounding interest is that you’re earning interest on interest, super-charging your savings.

And this same compounding concept can apply to share market investments – the longer you keep quality stocks, and keep reinvesting your dividends to earn even more the following year, the higher the overall return can be. Of course there are many variables involved, but as Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

We loved this story from Peter Warnes, head of equities research at Morningstar, which helps demonstrate the power of compounding returns:

Listen for the compounding engine

Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

Just the other day I was talking with a friend and very proud grandmother whose granddaughter was turning 21. This is the fourth grandchild of five to have reached this traditional milestone.

She was a little embarrassed. She and her now deceased husband bought Commonwealth Bank of Australia (CBA) shares when they listed in September 1991 at $5.40 per share. From their holding they transferred 2,000 shares into a trust when a grandchild was born, to be a 21st birthday present.

The dividend reinvestment plan (DRP) option was activated at the outset. Since birth in 1994, dividends totalling $43.85 per share or $87,700 have been reinvested via the DRP.

The granddaughter is about to be given shares worth $195,000. The embarrassment comes from the apparent inequity in the grandmothers' eyes. The first grandchild only got $65,000 odd, the second $85,000 odd, the third $125,000 odd and now $195,000 for the latest 21 year old.

The remaining granddaughter just turned 18. How embarrassed will my friend be in 2018? This is a classic example of the powerful results of long-term investing and the potent impact of compounding.

I saw a quote in Wednesday's edition of The Australian Financial Review: "Buying CBA at $94 in the hope it's going to hit $150 may be considered delusional." I think grandparents buying 100 CBA shares at $94 for their newly born grandchild could also be financially embarrassed in 2036.

Would an active manager chasing quarterly performance have turned $10,800 into $195,000 over the past 21 years either by "trading" CBA shares or investing it somewhere else? No one knows, but I think not.

That bottom draw can be a very safe place. Even safer not knowing you own shares so temptation is not an issue. Too much knowledge can be and usually is dangerous.

Recall Warren Buffett's advice: "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years". If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes.

That advice could have saved many from selling CBA below $30 in the post-GFC rout. Even if the market was closed for 10 years dividends would still be boosting bank account balances on a six-monthly basis.

Why do we need to know the price of a stock every second of every day? Aren't we convinced we have made the right investment? Less grey hairs, less stress and better overall health could result if daily share prices were not reported.

But as humans we are all too focused on "how much am I worth" to worry about negative health implications.

Is your portfolio overdue for a health check? Would the financial stethoscope hear a slow, even heartbeat and sound lung function providing the owner with comfort the inner workings are in good order.

Are there extremities suffering from lack of blood flow requiring surgery or even amputation? We worry about daily share price movements, but how often do we have a portfolio health check? We need the portfolio to outlive us, not the other way around, so it is imperative to have regular check-ups.

We have our motor vehicle, a depreciating asset, serviced annually. We should ensure our portfolio, hopefully an appreciating asset, is serviced more often. That does not mean paying fees. It should be a process where each individual holding is stress tested, and if it is performing as you expected and is contributing as per your overall investment strategy, leave it alone.

The bottom draw can work, but human nature will tempt its opening. Untouched, long-term investment returns have a good chance of beating the regularly disturbed. Think of the lucky granddaughter.

At The Super Fund Co, we are very conscious of harnessing the power of compound returns and are consequently long term investors. Our annual portfolio reviews are our “health checks” for our clients, to make sure there is a slow, even heartbeat and sound lung function :) We want to help you reach your retirement as soon as possible!

If you have any questions about compounding returns or would like to find out more, don’t hesitate to get in contact.