“The first rule of compounding: Never interrupt it unnecessarily.” – Charlie Munger
There are few things more liberating or remarkable in the investing world than having your money work for you, rather than you for it. This is achieved by compounding your assets over time. But this doesn’t happen overnight, it happens slowly by consistently contributing to your investments and allowing them to grow. Think of compounding your investments like compounding your skills. A probie (probationary, brand-new firefighter, police officer, paramedic etc.) isn’t expected to possess the skills necessary to run an entire emergency scene by themselves, nor would that ever be feasible. A competent captain is responsible for that. Did that person just randomly start being a captain and felt confident in their skills? No, of course not. Those skills took years to appreciate. Skill by skill compounded over a long career to arrive in the captain’s position ready to take on any challenge that is presented. This is how you should frame your investment goals. Growing slowly (but consistently!) over time. Imagine if you are a new first responder, or a seasoned one, would you feel comfortable running an emergency scene in your first year? Almost certainly not. So, we need to change our mentality of rejecting the allure of these overnight success stories of people getting extremely lucky in the stock market and appreciate, or dare I say embrace the slow and powerful force of compounding. The end results will be staggering.
Harnessing the power of compounding for positive results is necessary. Reducing our risk to negative compounding is equally critical. Think of negative compounding as sleep deprivation. This is something that any shift worker, regardless of title is acutely sensitive to. If we allow poor sleep to negatively compound for days, weeks, or months on end, the negative mental and physical health effects compound in a spiral. [1] [2] Perpetual sleep deprivation can lead to serious negative outcomes. [3] We must take care of sleep first before we can tackle many of life’s challenges. It’s a foundational health priority. Negative compounding in personal finance has the exact same spiral down unless it is properly addressed. Negative compounding can be categorized into two major segments, high interest debt, and high fees for the investment products we choose. High interest debt (HID) is straightforward. If you possess a lot of HID, namely credit card debt, pay day loans, or other forms of debt that, as a general rule are above 6%, then you should pay that off first. [4] This debt will negatively compound at a high interest rate that no matter how successful you are at investing, you are starting at such a disadvantage that it is unlikely to be feasible to ‘get ahead’ in life. I’ll cover debt in more detail in a future post, but for now, anything above 6%, that gets dealt with first. The reason is that depending on your risk tolerance, the likelihood of you generating an annual market return, minus the rate of inflation greater than 6% will be difficult over the long-term. [5] The second negative compounder is high fees. When we choose investments that have high fees, called the management-expense-ratio (MER), these fees negatively compound over time. To access financial products, everyone must pay for that service. This is reasonable and fair. We are paying for a product. Where a lot of people make mistakes is overpaying. They are buying financial products with high expense fees. The difference between buying an investment product with low annual fees (less than 0.5%) versus one with higher fees (anything greater than 0.5%) can be a loss of hundreds of thousands of dollars over your investing lifetime. The way most financial products work is the annual fee is charge of your overall investment portfolio amount. So, for example, if you have a $10000 investment account, a fund with an MER of 0.15% charges an annual fee of $15, whereas if you chose a fund with a fee of 2.5% the fees would be $250. That might not seem like a big difference right now, but if you compound that over twenty-five-years the difference in fees would be tens or hundreds of thousands of dollars.[6] On a million dollar portfolio (yes this will be possible) those fees are $25000 a year for the 2.5% fee fund or $1500 a year for the 0.15% fee fund for just one year! This is negative compounding in action. Think of fees as a HAZMAT incident, you want the least amount of exposure to the chemical as possible. It is the same in investing. You want the least amount of exposure to high fees. Understanding the power of negative compounding and avoiding it with low fees may be one of the biggest money saving choices you will ever make. The following graphic shows how dramatic high fees are. It is imperative that you find an investment products with the lowest fees possible.
At this point some of the numbers and terminology may be overwhelming. That’s okay to feel this way. I remember being overwhelmed when I started (in firefighting and investing). For now, the key piece from this lesson is knowing that compounding is both a friend and a foe. We just need to make sure we choose the correct route. I will get more into specifics about fund types, fees, and the more complicated things in the future. But understanding these basics, like getting proficient with our skills early on in our careers will allow us to compound into greater things in the future.
Next up we are going to discuss a topic that likely either hinders people from starting to invest, or makes it untenable for them to continue, and that is volatility.
The content provided by Beyond Your Pension is intended for educational purposes only and does not constitute personalized financial advice. Please consult a qualified financial advisor for guidance specific to your individual circumstances.
[1] Costa, G. (2015). Sleep deprivation due to shift work. Handbook of clinical neurology, 131, 437-446.
[2] Haus, E. L., & Smolensky, M. H. (2013). Shift work and cancer risk: potential mechanistic roles of circadian disruption, light at night, and sleep deprivation. Sleep medicine reviews, 17(4), 273-284.
[3] Kecklund, G., & Axelsson, J. (2016). Health consequences of shift work and insufficient sleep. Bmj, 355.
[4] https://www.fidelity.com/learning-center/personal-finance/pay-down-debt-vs-invest
[5] Šindelář, J. (2022). Can active investment managers beat the market? A study from the US large cap equity segment. Finance Research Letters, 50, 103204.
[6] https://www.nasdaq.com/articles/visualizing-how-investment-fees-impact-your-portfolio
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