Stock Market Returns - The Wonder of Compounding

By: Prieur du Plessis | Sat, Jul 26, 2008
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Albert Einstein described compound growth as the eighth wonder of the world. Although he may have passed away in 1955 - coincidentally the year when yours truly saw daylight for the first time - the concept of compounding remains the single most important principle governing investment.

Back to basics: Compounding simply means that you can earn interest on your principal investment amount, as well as earn interest on top of interest. The power of compounding can make an investment grow much faster than would otherwise have been the case, and is obviously based on the assumption that interest or dividends are reinvested in the same asset.

The raison d'être of investment or wealth management is to maintain, or hopefully improve, one's standard of living, i.e. to earn a real return on the investment amount. This sounds easy enough if one considers that the S&P 500 Composite Index (and its predecessors) delivered a nominal return of 9.1% per annum from January 1871 to May 2008. With an average inflation rate of 2.2% per annum over the period, this meant a real return of 6.9% per annum.

These figures may not particularly appeal to many of today's market participants with their gun-slinging approach. I am deliberately refraining from using the word "investors" and can hear these people arguing that much better returns can be generated by "playing" the market cycles. Ah, the art of market timing! Perhaps, but keep in mind that very few people have succeeded in consistently outperforming the market over any extended period of time, especially once costs and taxes are factored in.

More compelling proof that the odds are stacked against the capital-growth-only brigade is gleaned from an analysis of the components of the total return figures. Let's go back to the total nominal return of 9.1% per annum and see how that was made up. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 2.1% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!

Still doubting the evidence? Have a look at the following chart:

And for good measure, here are the numbers summarized in table format.

Source: Plexus Asset Management (based on data from Prof Robert Shiller and I-Net Bridge)

In an environment characterized by increasingly shorter investment horizons, the concept of compounding sounds so yesteryear, but who can argue with the body of empirical market evidence? To coin a phrase often quoted, but seldom fully appreciated (or understood): It is time in the market, and not market timing that counts.

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Prieur du Plessis

Author: Prieur du Plessis

Dr Prieur du Plessis
investmentpostcards.com

Dr Prieur du Plessis

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

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