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By Jonathan Spring: When I was just getting my arms around investing about ten years ago, having heard much talk about the “miracle of compounding,” I sat down with a spreadsheet to see just how much of a miracle compounding really is. First, I assumed I was lucky enough to have $1 million I didn’t need in 1900 and had stashed it away in a savings account that yielded 5% annually. By 2000 my hypothetical bank account was showing a balance of $131,501,258. Suppose I could have been prescient enough to invest in a basket of U.S. stocks that returned 10% annually? One hundred years later my heirs would theoretically be sitting on a $13 billion nest egg. A miracle indeed! Why wasn’t everybody following this easy road to riches? After a little head scratching I realized that taxes and inflation are two harsh nightmares that might interrupt dreams of compounding one’s way to easy wealth. So I went back to my spreadsheet and did some more calculations (which I will present momentarily). Oops, compounding effects are seriously beat up by taxes and inflation over time; what a drag!
Many years later, as I became more experienced, I identified a third factor that has deleterious effects on compounding: volatility. And in February, 2002 I wrote an article demonstrating the potential friction inflicted by both market volatility and volatile investor behavior. My conclusion was that, given any two normally distributed return streams with the same average return, the less volatile o...................... To view our full article Click here
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