Allegedly referred to by Albert Einstein as the most powerful force in the universe, possibly the eighth wonder of the world, compounding is a critically important part of any investment strategy.

So, what is this potent financial force exactly?

According to Darron West of Foord Asset Management, simply put, it is about earning a return on an investment, and then earning subsequent returns not only on the investment but on the returns already earned, which makes for still higher returns.

"A trite example of the power of compounding is that of the sale of Manhattan by the native Americans to the Dutch in 1626. The consideration was apparently in kind (beads and trinkets) with a value of 60 guilders (equivalent to about €27). At the seemingly paltry return of just seven percent per annum, those 60-guilders would have been worth about 10-trillion guilders (€4.9-trillion or US$3.7-trillion US) today, 383 years later. An incremental 0.5 percent additional annual return would make the original investment worth 64-trillion guilders (€29-trillion or US$22-trillion US), over six times more. The estimated value of Manhattan real estate today? A mere US$259-billion US dollars."

Whilst somewhat extreme, since few investors have a 383 year investment horizon, West says that the Manhattan anecdote illustrates two key points: first, that the real power of compounding is evident over long periods; second, that even an incremental improvement in return can compound into stupendous results.

According to West, investment is about the long term and not about a quick profit. This is often regarded as simple, sage advice, but why?

Over a long term returns become predictable

"Shorter investment horizons can expose the investor to the risk of loss (owing to price volatility, which tends to be fuelled by sentiment). Over the longer term, price volatility (and sentiment) pales into insignificance and returns become somewhat more predictable and less volatile. Hence, an investor with a longer horizon not only derives comfort from the comparative predictability of returns, but he or she can allow those more predictable returns to compound."

It almost goes without saying that if you are going to compound, it is important to compound positive numbers.

"The corollary to investing and compounding returns over long periods is to commence investing as early as possible," explains West. "Consider the twins A and B who have identical earnings. A begins saving for retirement at age 20 and, deciding that surplus cash would henceforth best be spent on hedonistic pleasures, ceases contributions at age 29 (i.e. after contributing for 10 years). After a pleasurable and hedonistic youth, B has an epiphany and begins saving at age 30 without ceasing contributions.

"At a rate of return of 11.35 percent per annum (which most would consider conservative), and despite having ceased making contributions after age 29, A’s wealth will be double B’s at age 60. Thus, it would seem, 10 years appears to do the work of 30 years. However, this is not so: it is the 10 years of saving compounded for the next 30 years that creates the result."

Even incremental returns can compound into surprisingly material outcomes, says West. "For most investors, the clear starting point is to seek additional returns over the mean — this is occasionally referred to as 'alpha'."

"Whilst alpha is an obvious source of incremental returns, it needs to be consistent. Consistency tends to be demonstrated by skilled fund managers over the longer term."

For many investors seeking alpha is a favourite pastime, often manifesting in switching from an investment to the latest (albeit historical and often short-term) best performer. If an investor’s strategy constantly changes by switching from one type of investment to the next to chase the perceived best return, there are two likely outcomes, explains West:

Investors seeking 'alpha' often realize losses to their detriment

"First, the investor may be affected by poor timing — too many people lose patience or faith (or both) and sell assets when they are cheap (or buy them when they are expensive). By making this mistake investors deprive themselves of the opportunity to compound positive returns over the long term. Instead, they often realize losses to their detriment.

"Second, costs are incurred each time one moves money from one investment to the next. Great or small, such costs erode returns and diminish wealth. Whilst seemingly less obvious than seeking alpha, lowering costs represents an easier, more certain method of earning incremental returns."

West goes on to explain that inasmuch as positive returns are earned by the capital growth of one’s investments, they are also earned by the income and dividends yielded by those same investments. "Many investors, particularly those caught up in the euphoria of bull markets, are blinded to the importance of a dividend yield by the apparently easy gains from price movements. However, in weaker markets dividends matter more since they are often the only positive return enjoyed by investors. Quality, long-term investments are in companies where the dividend is stable and growing so that it remains an important component of the total return on the investment.

"Furthermore, when such dividend income is not required to supplement other earnings, reinvestment of those dividends allows returns to be compounded on the dividends too, so further enhancing long term returns. Over an average five-year period in South Africa, investors who reinvested their dividends from equities would have had 30 percent more wealth than similar investors who did not reinvest.

"The power of compounding is one of the important keys to wealth. In this instance patience is truly a virtue and the selection of a skilled fund manager with a consistent long term track record of success is essential. With the requisite discipline and discernment, investors should reap handsome rewards," concludes West.

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