EARLY AND OFTEN

A LOOK AT THE MATH OF COMPOUNDING

June 2, 2016

When they think about their investments, many people focus on performance.  While clearly higher returns give better results, performance is not the only factor to consider when it comes to assessing investment success.  Unfortunately, performance is not something that is within our control.  Markets go up and down, often with some irrational periods.  We can, and do, make every effort to find the best managers, but over shorter time frames anything can, and does happen.  But over the longer term, markets have always gone up, and we believe that trend will continue in the future. 

So, given that we cannot control performance, and that long term investing pays off, what is the best approach?  One thing that is in our control is how much we put aside to save and invest.  While that amount varies widely from individual to individual, the real key to investment success is to have an investment program, to start it early and contribute to it on a regular basis.  It’s all about compounding, which has been referred to as the eighth wonder of the world.  So let’s look at the math.

The so-called Rule of 72 is a simple way to look at compounding.  To find out how long it will take an investment to double in value, simply divide 72 by the expected annual average rate of return.  If you are expecting an average annual return of 6%, your investment will double in 12 years.  The “magic” of compounding is all about time.  But it’s hardly magic – it’s all about putting money aside to invest and then sticking with that approach over an extended period of time.

Most of our clients are not just embarking on an investment program.  They have had one in place for many years.  Their time horizon is much shorter than their children’s.  It’s their children – that generation – who have the most to gain from compounding.   But for that generation, it’s really tough to put aside much for investing.  For most, it can only be done by sacrificing some “in the moment” things.  And in my recollection, that’s often pretty hard to do.  It really comes down to the old adage of “short term pain for long term gain.”  But it doesn’t have to be “pain.”  It does, though, have everything to do with priorities.

In my parents’ generation many companies offered defined benefit pension plans.  I’m not saying that meant, by itself, a comfortable retirement, but it certainly helped.  Today, among public companies, that support is no longer there.  And, if you choose to go out on your own and launch your own business, retirement planning is all up to you.  The bottom line is that today, most people have to develop their own “pension” plan.  And, because of that, the “early and often” approach is immensely important.

We have seen how important the investment time horizon is in the compounding equation.  The other major factor, of course, is rate of return.  Obviously, the longer the time frame involved the more important return is.  For those investors with shorter time horizons, our view has always been that you should not take more risk than you need to to reach your objectives.  What that return number is is hard to quantify without a detailed financial plan.

For those in their 20s and 30s, the time horizon is very long.  Other things being equal, starting an investment plan as early as possible makes a tremendous difference over the long term.  The point is that you need to find a happy medium between your long-term financial goals and the risk you are comfortable taking to reach those goals.  The best approach, I think, is to ask yourself this question:  is the risk of running out of money greater or less than the risk you will experience some volatility along the way.

Clearly, there are many components to a good long term investment plan.  But two of the most important words to keep in mind are “early and often.”  For most of us there will be some shorter-term sacrifices that may have to be made.  Most of us do not have a defined benefit pension plan to rely on, and income from government programs alone does not make for a comfortable retirement.  That result, today, is mostly up to us.

Howard Goodman
President, HG Partners Limited
Director, Private Client Group &
Senior Financial Advisor,
HollisWealth Advisory Services Inc.

This article was prepared solely by Howard Goodman who is a registered representative of HollisWealth Advisory Services Inc. (a member of the Mutual Fund Dealers Association of Canada and the MFDA Investor Protection Corporation).  The views and opinions, including any recommendations, expressed in this article are those of Howard Goodman alone and they are not those of HollisWealth Advisory Services Inc.

HollisWealth is a trade name of HollisWealth Advisory Services Inc. ® Registered trademark of The Bank of Nova Scotia, used under license.

HG Partners Limited is an independent company. Scotiabank companies have no liability for activities outside of HollisWealth.