Over the course of the last 50 years, from 1972 to 2021, the S&P 500 saw average annual returns of 9.4% per year.
When we look at that figure over the course of a single year, it might not seem all too impressive. If you invested $1,000 and earned 9.4% over the course of the year, then you’d have turned your initial investment into $1,094. That’s nothing to sneeze at, but $94 also isn’t exactly life-changing money for most people.
That is, until you zoom out and see just how much that growth can compound over time. If you invested $1,000 in 1972 and earned an average return of 9.4% each year, then after 50 years you would have just under $108,000 in your account. In other words, you’d have multiplied your money by 108x—and that’s without even adding in any additional funds. If you’d invested an additional $100 per month for that entire period of time, your final portfolio would have grown to nearly $1.5 million.
This is thanks in large part to the magic of compounding, which over time can turn even small sums of money into a significant nest egg.
Below, we take a closer look at compound interest and the role it plays in growing your investments. We also take a look at how a single year of large losses can derail your entire investment strategy—and why it’s so important to position yourself in a way to avoid them when possible.
What is compound interest?
Compound interest is a term used to describe the phenomena of an interest payment earning its own interest. It quite literally means that interest is compounding, or intensifying, over time.
If that sounds amazing, it’s because it is: Albert Einstein reportedly once said: “Compound interest is the most powerful force in the universe.”
By taking advantage of compound interest, investors can realize significant gains over the long term. In fact, it’s through compounding that most investing fortunes are made. As we saw above, it’s what allows a $1000 investment to turn into $108,000 after 50 years of growth.
What is the compound annual growth rate (CAGR)?
Compound annual growth rate (CAGR) is a measure of the rate at which an investment is compounding. CAGRs enable us to look beyond volatility and compare the performance of different investments when deciding where to invest our money. The higher the CAGR, the better the (past) performance.
For example, let's say an asset is currently selling for $100 and that over the course of the next 5 years it has the following yearly returns: 10%, 21%, -5%, 7%, -15%.
If we apply those returns to the initial $100 price, we see that at the end of 5 years the "compounded" price of the asset will be $115:
Year 0: Start --> $100.00
Year 1: Gain 10% --> $110.00
Year 2: Gain 21% --> $133.10
Year 3: Lose 5% --> $126.45
Year 4: Gain 7% --> $135.30
Year 5: Lose 15% --> $115.00
Now, the CAGR of this asset will be the constant yearly return that would have produced the same $115 price at the end of those 5 years.
In this case, the CAGR is 2.83% because if the asset had earned a 2.83% return each year for 5 years, the price of the asset would have ended up at the same $115 level:
Year 0: Start --> 100.00
Year 1: Gain 2.83% --> 102.83
Year 2: Gain 2.83% --> 105.74
Year 3: Gain 2.83% --> 108.73
Year 4: Gain 2.83% --> 111.81
Year 5: Gain 2.83% --> 115.00
How Large Losses Disrupt This Growth
While it’s fun to talk about growth, it’s also important to acknowledge that losses do occur. Over the long term, it’s incredibly unlikely that an investor will never experience a down year.
That being said, it’s in our best interests as investors to try and avoid especially large losses, as they have the potential to blow a hole in our portfolios. To understand why, we need to look at the math of percentages.
When we experience any kind of loss, we must then realize an even greater gain simply to break even. For example, a portfolio that loses 10% must then gain 11% to get back to where it started. And the greater the loss, the larger return it’ll take just to break even. A loss of 50%, for example, would require a subsequent gain of 100% to recover one’s losses.
It’s also important to note that the timing of a loss can make a big difference in just how detrimental it will be to a portfolio. If you experience a 50% loss early in your investment career, it might be painful, but you have the time to recover, thanks to the power of compound interest discussed above. But if you experience that same loss toward the end of your investment horizon, you might not be able to recover. This is why portfolios tend to get more conservative over time—to reduce the risk of such significant losses.
Steps You Can Take
All investments involve taking on some level of risk. Indeed, it’s that risk that provides us with the opportunity to earn a return. Nonetheless, it is important to make sure you are taking on a level of risk commensurate with your investment timeline and financial goals.
You can do this in a number of ways. The first is to embrace a well-diversified investment portfolio that includes a variety of asset classes. This way, if one segment of your portfolio experiences a loss, there’s the potential that the other asset classes can help to stabilize your portfolio.
Additionally, regularly contributing to your investment accounts over the long term through a process known as dollar-cost averaging may allow you to smooth out some of the volatility your portfolio sees, especially when compared to lump-sum investing.
Finally, it’s always advisable to understand the specific role each asset will play in your portfolio before you choose to invest. You may, for example, include certain assets in your portfolio because of their opportunity for growth. While other assets you might include simply because they offer stability, or because they are a hedge against certain risks like inflation.
Understanding the role each component of your portfolio is meant to play will empower you to better evaluate assets. It may also keep you from panicking—and altering your investment strategy for the worse—during periods of volatility.
Here at Allio, we know just how detrimental significant losses can be to an investment portfolio. That’s why we provide our clients with the education, strategies, and tools they need to reduce risk to reasonable levels while still working toward their financial goals.
