Stock market returns - The wonder of compounding

Albert Einstein described compound growth as the eighth wonder of the world. Although he passed away in 1955, the concept of compounding remains the single most important principle governing investment.

According to Dr Prieur du Plessis, chairman of Plexus group, compounding simply means earning interest on the principal investment amount, as well as interest on top of interest. “The power of compounding can make an investment grow much faster than would otherwise have been the case, and assumes that interest or dividends are reinvested in the same asset,” says Du Plessis.

The purpose of investment or wealth management is to maintain or hopefully improve one’s standard of living, in other words to earn a real return on the investment amount. This sounds easy, considering that the FTSE/JSE All Share Index delivered a nominal return of 17,1% per annum from January 1960 to June 2009. With an average inflation rate of 9,2% per annum over this period, this meant a real return of 7,9% per annum.

According to Du Plessis, these figures may not particularly appeal to many of today’s market participants with their gun-slinging approach. “I deliberately refrain from using the word ‘investors’, as I hear these people arguing that much better returns can be generated by ‘playing’ the market cycles,” he says. “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 analysing the components of the total return figure, says Du Plessis. “Of the total nominal return of 17,1% per annum, 9,2% per annum came from inflation and real capital growth (i.e. price movements net of inflation) added another 3,1% per annum. The remaining 4,8% per annum came from dividends, slavishly reinvested year after year. This represents more than half the total return over time!”

“In an environment characterised by increasingly shorter investment horizons, the concept of compounding sounds so outdated,” says Du Plessis. “But who can argue with the body of empirical market evidence? “Ultimately, it is time in the market, and not market timing that counts.”