Returns and Compounding - A Simple Viewpoint

Discussion in 'Financial Planning' started by kierank, 16th Jan, 2020.

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  1. kierank

    kierank Well-Known Member

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    Today, I was asked by a (younger) cousin to help them out with their Net Worth journey.

    They are fairly conservative by nature. Their Super has been producing yields of around 6% to 7% pa and I was insisting they should be getting 9%+. They were of the opinion that the 2% to 3% variance wouldn't make that much difference in the long-term.

    They were asking me why I am so adamant about Investment Returns and Compounding. It started out as a phone call; then I backed it up with an email.

    I thought I would share part of that email on PC as it might help other newbies. Here it is:

    "Returns and compounding are the name of the game. I assume you are aware of the Rule of 72. This rule means that:
    1. If one’s investments are Aggressive (say, 12% pa return), then one is aiming to double the value of their investment every 6 years (that is, 72 / 12%).

    2. If one’s investments are Balanced (say, 9% pa return), then one is aiming to double the value of their investment every 8 years (that is, 72 / 9%).

    3. If one’s investments are Conservative (say, 6% pa return), then one is aiming to double the value of their investment every 12 years (that is, 72 / 6%).

    4. If one’s investments are in Cash (say, 2% pa return), then one is aiming to double the value of their investment every 36 years (that is, 72 / 2%).
    Note:- these returns are before tax and before withdrawals.

    The lessons from the above:- Cash Only is risky (to Net Worth creation). Also, the above shows that it takes 50% more time for a Conservative Investment to reach the same destination as a Balanced Investment AND double the time as an Aggressive Investment.

    Therefore, Conservative Investment can be considered risky as well, especially if one is still reasonably young. I am not a big fan of Aggressive investments due to the risk of losing capital.

    In summary, I prefer Balanced investments or higher and, as one ages, one should lower the risk (and the return). I don’t know whether I will ever get as low as Conservative.

    If one looks at our Asset Split, one can see that we have a lot of growth assets (88%).

    Even if one looks at our Net Worth Split (assets – debt), one can see that we still have a lot of growth assets (83%)."​

    That simple explanation really hit home for them and gave them a few things to think about. I hope it might make some sense to others.

    PS
    I selected returns like 12%, 9%, 6% etc to prove a point (and they were easily divisible into 72 :)).

    Obviously, one can plug in one's own numbers to prove a similar point.
     
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  2. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    With declining yields your well intentioned but possibly unqualified advice is that they must chase high risk for maintaining yield. To increase yield means adopting ever increasing higher risk. And a 9-12% that may be significant. This is the risk v reward trade off.

    Growth calcs also must factor in expected adverse movements. The higher the yield the more likely a adverse impact event will revert the return. ASIC describes it here. And then...

    For a 40% loss it requires a future 66.66% growth to merely restore the original capital. The main ASX index took 10 years to recover from the GFC impacts. I will always argue that if someone cant forsee a 40% fall they cant forsee the next growth surge. Obviously some listings under performed (or went bust) and others out performed.
     
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  3. Trainee

    Trainee Well-Known Member

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    When it comes to property though the calc is very different. Is a property riskier because there is a mortgage?
     
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  4. spludgey

    spludgey Well-Known Member

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    I agree with you.
    Simplified table here. I did it for an annual contribution of $6k (after fees). Not accurate, but good enough to get some sort of feel for it.

    upload_2020-1-17_11-38-58.png

    Also, I'm not that big a fan of the 72 method, as it doesn't work well at the extremes.
     
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  5. kierank

    kierank Well-Known Member

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    In my OP, I was referring to cash contributions to keep it simple but one could take out a loan to buy shares if one wants to increase the risk (and potential reward).
     
  6. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    A mortgage is just loan security. It is only a issue where the income ceases and the fund lacks capacity to meet its obligations. Then the fund will have other choices

    1. Rollover ?
    2. New members ?
    3. Redirect contributions as new stream of cash ?
    4. Director guarantee (bank will decide that)
    5. Sale of property by owner or lender
    Refinance isnt generally a option if lack of liquidity + default approaches.

    Property and shares are both passive investment. Unlike shares which can be exchange traded property comes with slower outcomes, costs of selling and in some cases buyers may dictate price when demand is low. A poorly presented property may also suffer in value if the vendor cant afford to present it well due to cashflow eg repairs are needed.

    Market v's specific asset risk is also a consideration.
     
  7. kierank

    kierank Well-Known Member

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    As I stated in my OP, I only posted part of my email on PC. I did close off my email with the following:
    "The above are my thoughts/opinion and is NOT advice (as I am not qualified/certified to give financial advice)."​

    I was more focussed on Total Returns (growth + yield) for investments, not yield per se. In the introductory part of the email (which I didn't post on PC), I did state:
    "This highlights that Aggressive investing over time should yield higher returns and Conservative investing lower returns. This is the Risk/Reward ratio."​

    My email was aim at educating them in investment concepts, not advice on any particular investment or strategy. Maybe, I might have been better to include more of the email but I thought that would make the OP too long. I do appreciate everyone's feedback.

    Unfortunately, their current (qualified) financial planner has them invested in up to 50% cash (for the 18 last years). They are disappointed with the returns they are getting and they see it having a huge impact on their retirement options (unless they take corrective action). My email was aimed at addressing their lack of knowledge in this area.
     
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  8. oracle

    oracle Well-Known Member

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    The law as it stands only allows people with financial planning degree to give financial advise. Whether that advise works for the client in the long run is irrelevant. People who have experience and runs on the board are normally looked down by the financial planning industry as being unqualified and against the law.

    The irony is when it comes to finance and investing this is the only industry where a completely uneducated and/or no finance/investing interest person can vastly outperform someone with a Phd qualification in finance. They only need to do few simple things right. In no other industry you would see this happen.

    Cheers
    Oracle
     
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  9. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    Thats not presently the law. There is a process for those without degrees to move to that or exit the industry. A degree doesnt mean the advice will improve if the industry still does the wrong thing. It may take some time to lift practices. The FASEA exams etc will help a bit. A lot are about to get a rude shock when they fail.

    Its like tax. Having a degree doesnt mean jack. You can have a accounting and business degree and no skills, language skills, experience. That said the TPG keep the riff raf out by applying tight rules to allow people to practice and then register in tax. But not while they are a employee ! They just must be supervised.
     
  10. kierank

    kierank Well-Known Member

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    Another way to demonstrate the above is provide closing balances after the same set period of time. For example, if one had, say $100,000, made no further contributions and no withdrawals, then, after 36 years, for:
    1. Cash Only investments (say, 2% pa return), the closing balance would be $204,000
    2. Conservative investments (say, 6% pa return), the closing balance would be $815,000
    3. Balanced investments (say, 9% pa return), the closing balance would be $2.2M
    4. Aggressive investments (say, 12% pa return), the closing balance would be $5.9M
    Note:- these returns are before tax.

    Clearly show that Returns and Compounding are the name of the game.
     
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  11. Paul@PFI

    [email protected] Tax Accounting + SMSF Business Plus Member

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    Its a bit flawed in the assumption that growth is always progressive. If a financial adviser did that ASIC would take your balls (and bat.) and call time on the game

    ASIC consider the returns and the correlation to expected loss potential here : Choose your investments | ASIC's MoneySmart

    Losses can impact equally as growth does eg In June 2019 the ASX 200 was 1% off the 2008 GFC highs. The losses in 2008 took 11 years
     
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  12. PandS

    PandS Well-Known Member

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    good old theory vs reality.

    it doesn't work like that in real world because to get that figure you always need a positive number , once a -ve number comes into the picture it a very different number and adding it up and using an average number is also flawed

    and because there is only 100%, a -30% or -50% negative years will takes you many many years of compounding to go back to the original number.

    ASX get 2 years of negative hit during the crash and it took you 10 years to go back to where it was so technically you lose 10 years of growth, there is no compounding during that period

    Not saying compounding doesn't work it just not as good in real world as on paper
     
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  13. Gestalt

    Gestalt Well-Known Member

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    You’re ignoring dividends. The accumulation indeces demonstrate that even in the decade following the GFC, compounding continued to work its magic. It may not have been spectacular growth, but it worked nevertheless.
     
    Last edited: 23rd Jan, 2020
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  14. PandS

    PandS Well-Known Member

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    I didn't say it doesn't works it just the figure is a lot smaller than on paper else everyone will be retire with millions in nest eggs because they contribute hell of a lot more than 6K a year in Super.

    To get a good number you need to manage your investment so you don't get quacked with a big -ve number in bad years, even if it doesn't grow as long as it doesn't goes backward you are ok, that is the assent of compounding formula, also fees, tax and various other cost comes into play and taking them out is also a big flaw as taking them out making your compounding number looked good but when you factor them in it doesn't look as good due to the nature of compounding.

    Using compounding formula without factoring in fees, cost and tax is like Gross yield on properties or EBITDA for a business, they looked good until you factoring all other cost.
    that why for business I don't care about EBITDA number I care about NPAT
     
    Last edited: 23rd Jan, 2020
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  15. Gestalt

    Gestalt Well-Known Member

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    If what you are saying is that it's the geometric mean, not arithmetic mean, that matters for compounding (or put another way, sequence of returns is critical) I'd agree. And net return, not gross, is what delivers the compounding return.

    But your original post didn't talk about costs at all. I was responding to your narrower, oft-cited, assertion that 2008 to 2018 was a lost decade for Australian equities. It wasn't, unless you ignore dividends, which makes as much sense as ignoring costs.
     
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  16. PandS

    PandS Well-Known Member

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    Fair call :)
     
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  17. significance

    significance Well-Known Member

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    When considering your strategy and risk appetite, it is important to consider your goal, what you'd be content with, and what you can recover from. If you young and healthy, you can afford to take a more assertive strategy with a higher expected return because if you lose capital in a downturn, you have time to recover and rebuild your investment, so your expected retirement income with a more assertive strategy will still be higher even if there are short-term losses. As you get closer to retirement, you have less capacity to rebuild, so you will probably want a more conservative strategy.

    It's best to do your calculations for a range of scenarios rather than assuming the same yield every year. Most years, you'll see growth, but in some years, you'll see a loss. With a more aggressive strategy, you can expect a higher average return in the long run, but losses will occur more frequently. Try your calculations for a few cases.

    To take a highly simplified example, let's say you have a strategy with an expected return of 9% 4 years out of 5 and an expected loss of 9% 1 year in 5. In reality, the loss years will be fairly randomly distributed and you probably won't be able to predict them. I've run the numbers for three highly simplified scenarios: In scenario A, you get a loss in the 1st year and every 5 years after that. In scenario B, you also get a loss every 5 years, but the first loss is in year 3. In scenario C, it's the same, but the first loss is in year 5. In scenario A, you are unlucky in your first year, but quickly recover due to the cumulative growth of your annual $6K contributions. That you had a loss one year doesn't matter because you are in it for the long haul. In scenario C, you are doing well in your first few years, but you take a big hit in your last year before retirement. You might have been better off switching to a more conservative strategy a few years before retirement, locking in the gains from the years of long-term investing in your youth.

    For a real planning tool, I'd set up a tool to run a few hundred scenarios with several different investing strategies, and explore the probabilistic range of outcomes expected if switching between strategies at different ages.
    upload_2020-1-23_12-16-21.png
     
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  18. kierank

    kierank Well-Known Member

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    I am talking about returns, not growth. I keep referring to returns and you keep going back to growth.

    I never even said that returns on any investment are ALAWAYS progressive.

    But, since 1900, the Australian sharemarket has returned an average of 13.1% per annum. On average, 1 in 5 years, it has returned a negative result.

    https://www.marketindex.com.au/site...stics/historical-returns-infographic-2018.pdf

    In my original post, I used a return of 12% as an example of an Aggressive Return. If the Australian sharemarket has returned an average of 13%, I don't believe my assumption is flawed at all.

    Keep your knickers on :D.

    This thread never intended to provide financial advice, investment strategy, ... It was purely for educational and illustrative purposes only, especially for newbies.

    I assume you noticed the following definitions from the website
    Growth, Expected Return = 5.0%
    Balanced, Expected Return = 4.8%
    Conservative, Expected Return = 3.8%
    Cash, Expected Return = 2.7%​
    They're kidding, right? I know it is called SMART Money but ...

    I will stand by my illustrative numbers, thank-you. They may not be smart, but at least IMHO they are more realistic.

    Once again, you are talking growth. I am talking returns.

    My view is that people should invest in the sharemarket for income (any growth is a by-product) and they should invest in property for growth, especially with leverage (any income is a by-product).

    I know most/all certified financial planners don't think that way but ...

    So I don't focus on share prices, sharemarket growth/losses, ... That may not be smart but it is working for me.
     
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