The Power of Compounding

Apr 2015 //
Behavioral Finance

What causes investors’ portfolios to average annual returns less than 10% over a work career and retirement?  There are two primary reasons for such performance:  First, some people get frightened during bear markets and sell or reduce their investments when stock prices are low.  Second, some people don’t have all-equity portfolios, because they erroneously regard stocks as being too risky for the long term and regard counter-productively diversified (i.e., “di-worse-ified”) portfolios as being safer and more appropriate.  Today it would seem generous to regard a broad portfolio of bonds as capable of producing 3% annual returns in the future.  So if an investor devoted, say, 60% of his or her portfolio to stocks averaging 10% annual returns and 40% to bonds averaging 3%, the portfolio’s expected return would only be about 7.2%.  Simply stated, the more you add investments that aren’t capable of generating approximate 10% annual returns to your portfolio, the more your portfolio’s returns are likely to fall short of that important level—with significant consequences.  Put differently, the power of compounding is so great over a combined work career and retirement that small differences in average annual return produce big differences in outcomes.