Compound interest, often humorously dubbed “the eighth wonder of the world,” may not have a historical quote to back its grand title, but the principle behind the jest is no laughing matter. In this article, we explore the transformative power of compound interest through the lens of two investors with differing outcomes. This concept, though not officially recorded in the annals of history as a quote from a famed historical figure, captures the essence of its staggering potential in a way that resonates with many.
Picture compound interest as a snowball cascading down a slope: the higher its starting point, the more time it has to accumulate mass and momentum. In the realm of Investment Management, professionals strive to harness this compounding effect for their clients by overseeing asset portfolios and enacting strategies aligned with each client’s time frame and risk appetite.
‘Superinvestors’ are those exceptional investment managers who have showcased superior capital allocation skills by consistently delivering above-average returns over significant periods. Often, these investors have steered investment partnerships to impressive double-digit gains for decades—an extraordinary feat. As assets under management swell, it’s generally understood that the potential for future returns diminishes due to a shrinking pool of attractive investment opportunities. Nevertheless, a few have managed to compound their capital at remarkable rates, which is even more noteworthy considering they’ve achieved this while managing their partners’ funds.
We will engage in a hypothetical thought experiment to compare the long-term impacts of two contrasting investment trajectories. The first involves an investor who unfailingly earns an above-average 20% return throughout their entire career. The second describes an investor who has a varying rate of return.
Both scenarios offer rich insight into the mechanics of compounding and investment strategy, shedding light on how exceptional the discipline of investment management truly is when practiced at the highest levels.
Experiment One: Setting the Scene
Let’s introduce our two investors, Investor A, and Investor B. Each embarks on their investment journey with the same starting capital of $1 and a remarkable 50-year investment horizon.
Investor A follows a consistent approach, achieving a steady compounding interest rate of 20% throughout the entire 50 years. This strategy exemplifies the power of constant growth over a long period.
Investor B, in contrast, adopts a strategy with variable compounding rates: an aggressive 50% for the first decade, a solid 20% for the subsequent two decades, and a more conservative 10% for the final two decades. This approach leverages higher early gains that taper off as the investment manager matures, which can potentially lead to a larger final sum despite the reduced rates in the later years.
The growth of each investor’s portfolio can be estimated using the Future Value formula:
FV=PV×(1+r)n
where:
– FV represents the future value of the investment,
– PV is the present value or initial amount,
– r is the annual interest rate (expressed as a decimal),
– n is the number of years the money is invested or compounded.
- Investor A (Steady 20% Rate)
- First 10 Years: 20% annual growth, FV ~$6.19
- Next 20 Years: Continues at 20%, FV ~$383.38
- Final 20 Years: Remains at 20%, FV ~$9,100.44
- Investor B (Variable Rates)
- First 10 Years: High growth of 50%, FV ~$57.67
- Next 20 Years: Slows to 20%, FV ~$2,210.93
- Final 20 Years: Further slows to 10%, FV ~$14,874.03
Summary:
Investor A ends up with approximately $9,100.44 after 50 years with a steady compounding rate of 20%. Investor B, with a variable compounding strategy of 50% for the first 10 years, 20% for the next 20 years, and 10% for the final 20 years, ends up with approximately $14,874.03. Investor B’s strategy results in a higher final amount due to the aggressive growth in the initial years, which created a significant base that continued to grow at a decent rate.
The findings suggest that an investor who is able to implement a higher-returning strategy during the early years of compounding stands to benefit greatly from the increased initial capital. This allows for a slower compounding rate as the portfolio matures without significantly affecting the overall growth of the investment.
It is also worth noting the impact of asset growth in this scenario. While in an experimental setup where the initial investment is just $1, the effects might not be as clear, they become much more pronounced when we consider a more substantial initial sum, such as $1,000,000. With such an initial investment, the eventual outcomes for the hypothetical investors are striking approximately $9.1 billion for investor A, and around $14.9 billion for investor B. These figures are indeed remarkable, considering they originate from a starting point of one million dollars without additional contributions.
However, the experiment also illustrates that maintaining a consistent 20% return throughout the lifespan of a growing portfolio is an extremely challenging task. As the assets increase in value, the market inefficiencies that once could be exploited to generate significant returns diminish. Such inefficiencies become too small to have a meaningful impact on a large portfolio. Consequently, investors may need to assume greater risks to achieve the same rates of return that were obtainable with much less risk when the investment pool was smaller.
Therefore, it seems more practical to maximize returns by exploiting market inefficiencies while they are still impactful and transition towards a less risky strategy as the portfolio expands. This approach balances the need for growth with the realities of changing market dynamics as asset size increases.
Experiment Two: Inversion
In our second experiment, we’ll explore the implications if Investor B’s variable return rates were reversed. Investor A will continue to generate a consistent 20% return over their 50-year investment period. On the other hand, Investor B will exhibit a 10% return for the first 20 years, a 20% return for the next 20 years, and a 50% return for the final 10-year period. Let’s examine the potential outcomes of this scenario.
- Investor A (Steady 20% Rate)
- First 10 Years: 20% annual growth, FV ~$6.19
- Next 20 Years: Continues at 20%, FV ~$383.38
- Final 20 Years: Remains at 20%, FV ~$9,100.44
- Investor B (Variable Rates)
- First 20 Years: Slow growth of 10%, FV ~$6.73
- Next 20 Years: Higher growth of 20%, FV ~$258.01
- Final 10 Years: High growth of 50%, FV ~$14,878.16
Summary:
Investor A ends with a value of approximately $9,100.44, while Investor B reaches $14,878.16. Similarly, scaling up the initial sum to one million dollars, the end values would be approximately $9.1 billion for Investor A and $14.9 billion for Investor B. This implies that periods of substantial outperformance within a portfolio allow for flexibility during periods of lower performance, regardless of the sequence of returns.
The data suggests that higher return periods significantly enhance the absolute return of an investor’s portfolio over their investment career. This can be seen as an investor adopting a conservative approach early on to mitigate the risk of poor early performance that could halt investment activities. As their career progresses and their intellectual and investment capital grow, they may increase their investment activities.
As an investor’s assets under management grow, so does their market influence. It’s plausible that as an investment manager’s assets under management increase, they also become more experienced and knowledgeable in the investment space. They gain a broader network of resources and can exert more control over their investments by acquiring significant amounts and holding substantial voting interests. In this scenario, it’s conceivable for an investment manager to improve their portfolio’s return rate while also expanding their assets under management. It is crucial to discern whether this is due to greater influence, which leads to better decision-making, or if it is the result of a high-risk strategy that could incur significant losses.
Economic conditions are another reasonable consideration. It is well-known that economic cycles can cause investment strategies to fluctuate in popularity. This leaves windows during which strategies can be effectively employed to generate increased returns. As investors recognize these opportunities or as economic conditions shift, these windows may close. There may be long intervals before these specific strategies become viable again. This understanding offers comfort to investment managers starting firms during costly markets or periods of low performance. Moderate returns at the outset can swiftly improve as time passes and economic conditions evolve, presenting more opportunities and boosting returns.
In a 50-year investment career, numerous economic scenarios can influence the ability to achieve exceptional returns at different times. If market conditions enable consistent performance over time, an investment manager can still enjoy a successful career by remaining committed and capitalizing on high-performing strategies when opportunities arise.
Results:
The results of these experiments are intriguing. They indicate that investment managers can afford periods of lower returns if they can demonstrate a higher rate of return, whether early or later in their career, and still outperform on an absolute basis. However, consistently producing above-average returns is challenging in all scenarios. This study suggests that it may be more effective to generate highly attractive returns intermittently, accompanied by periods of lower performance, rather than maintaining consistently high returns throughout one’s career. These higher-than-average returns can be achieved early in a career by exploiting market inefficiencies and seizing opportunities, then reducing the aggressive strategy as assets under management increase. Conversely, a conservative approach implemented early on can yield average returns, with the potential for performance to improve over time based on enhanced skills, influence, and favorable economic conditions.
The results highlight the practical incentives of generating higher returns early in a financial career, emphasizing that smaller assets under management can contribute significantly to achieving higher returns. As assets under management grows, the potential for above-average returns tends to diminish exponentially. This phenomenon is evident in the career trajectories of many “super investors,” who often start with exceptionally high returns that taper off after decades of outperformance and asset growth. These investors may need to return money to partners or clients to sustain the high returns compatible with the levels of risk they are comfortable with. This aspect, not included in the experiment due to its complexity, can be thought of as a form of variable returns—not just from the portfolio that consistently performs well but also from the performance of funds reallocated or returned to investors.
The returns of the original proceeds that stay in the high-performing investment vehicle, and those of the subsequently returned proceeds invested elsewhere or held in risk-free alternatives, are difficult to quantify due to varying individual decisions. The fee structure of investment partnerships, such as carried interest, adds further complexity to these calculations. While the outcome—whether an investment manager consistently produces high returns and returns money or experiences variable returns—is partly circumstantial and mostly beyond control, understanding the limitations of assets under management growth is crucial.
An inverted variable rate scenario, where returns compound slowly initially and then accelerate, is unlikely. However, it serves to illustrate that periods of underperformance can be counterbalanced by periods of over performance. This is encouraging for investment firms that may start with challenges, such as entering overvalued markets or making miscalculated investments.
The mathematical implications of variable compounding rates are significant. For example, compounding $1,000,000 at 3% for the first 40 years and then at 50% for the last 10 years yields a final sum of $188,105,536.58. Conversely, compounding at 50% for the first 10 years and then at 3% for the remaining 40 years results in $188,105,536.69, differing by only eleven cents. These calculations demonstrate that high compounding rates significantly enhance the attractiveness of variable returns over an investment career. In comparison, compounding $1,000,000 at a constant rate of 10% over 50 years yields $117,390,852.88, less than the variable rate examples, even considering a lengthy period of underperformance.
The results suggest that periods of exponential compounding offer investors leeway for lower returns either in the past or future while still achieving a high absolute return. By generating exceptional returns when possible, an investor can afford periods of lower returns without eroding the overall portfolio performance throughout their career.
It is crucial to acknowledge the limitations of this experiment and recognize that both hypothetical investors, A and B, would be considered extreme outliers and “superinvestors” if they were able to produce such returns. This thought experiment was conducted solely to explore the dynamics of consistent versus variable rates of return.
These are, of course, theoretical amounts, not taking into account taxes, fees, investment risks, and other real-world factors that could affect investment growth. Please note that the calculations provided for the future values of investments for Investor A and Investor B were performed using mathematical approximations. The results may vary slightly due to rounding during the compounding process and the precision of the calculations. When applying these methods to actual investment scenarios, it is important to consider additional factors such as transaction fees, taxes, market volatility, and other economic factors that could affect the final outcome. The figures presented should be used as a general guide and not as exact predictions of future investment returns.
Key Takeaways:
- Timing of High Returns Is Flexible: The study suggests that the timing of when an investment manager realizes higher rates of return—whether early or later in their career—does not necessarily impact the end result significantly. Whether high returns are achieved through initial aggressive strategies or developed capabilities over time, both approaches can even out and result in impressive long-term wealth accumulation.
- The Power of Compounding Over Varied Periods: The compounding effect benefits both early and later high returns, but the approach can be adapted depending on the investment manager’s circumstances and market conditions. The advantage lies in the ability to compound at a high rate, regardless of when this occurs in the career span.
- Adaptability in Investment Strategy: Consistency in high performance is challenging to maintain. This experiment illustrates that adaptability in investment strategies—capitalizing on market inefficiencies early on or enhancing skills and influence to boost returns later—can be as important as the actual returns themselves. An investor’s ability to adjust their strategy in response to changing economic conditions and personal growth within their career can lead to overall outperformance.
This experiment implies that it’s not just about when you achieve your returns but also how you adapt and change your strategy throughout your investment career to maximize the periods when you can earn above-average returns.
In conclusion, the experiment’s findings challenge the conventional emphasis on consistently high returns throughout an investment manager’s career. Instead, it presents a compelling case for the strategic timing of when these returns are realized, whether early or later in one’s professional journey. The study illustrates that both approaches — capitalizing on early market opportunities or growing capabilities to achieve higher returns later — can be equally effective due to the enduring power of compounding.
The adaptability of an investment strategy in response to evolving market conditions and the manager’s own professional development is highlighted as a crucial factor in long-term investment success. The key takeaway is that while it is difficult to maintain above-average returns consistently, investment managers who can navigate the dynamic financial landscape and optimize their performance periods — regardless of their career stage — stand to accumulate significant wealth over time.
Therefore, this thought experiment underscores the importance of a flexible, adaptive investment approach over the rigidity of seeking consistent outperformance, reaffirming the notion that there are multiple paths to achieving exceptional long-term investment results.
The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.