Compound interest can potentially drive investment returns over a long time period, but there are a few things to consider, such as time, reinvestment and the importance of risk management.
Portfolio management is the ongoing maintenance of your long-term investment portfolio. It means reviewing your asset allocations, adding new money, reinvesting interest and dividends, managing risk by rebalancing, and maintaining a long-term perspective.
First things first. A long-term investor can potentially leverage the power of compound returns (commonly called compound interest in the case of bonds, certificates of deposit (CDs), and other fixed-income investments). Compound interest is essentially interest earned on top of interest. When it comes to compounding, there are three things to consider:
Compound interest has been called the eighth wonder of the world. And when you look at a chart like figure 1, the effects can be impressive. But really, it’s just simple math. But as we’ll see in the next section, it may be a little too simple, in that it doesn’t account for the setbacks, like corrections, bear markets, and recessions, that can occur along the way.
Suppose you have $1,000 earning 5% per year. That’s $50 per year, right? Yes, but then it starts to compound. After that first year at 5% interest, you now have $1,050. Add the same 5% interest and you get $52.50 the second year for a total of $1,102.50. The third year your total grows to $1,157.63 ($1,102.50 x 1.05). Yes, the extra gains over and above the original $50 in interest are small at first, but they pick up steam as time goes on.
That’s why it’s important to reinvest any compounded returns. If instead of reinvesting that $50 you withdrew it and spent it on a nice restaurant dinner, you’d earn only another $50 the second year instead of the compounded $52.50. There’s nothing wrong with the occasional splurge, but when it comes to investing for the future, you can’t have your compounding and eat it too.
Now that we've looked at the importance of time and reinvestment, let's turn our attention to risk. Over time, assets such as stocks or bonds grow at different rates. Bonds are designed to deliver a fixed rate of return and are typically viewed as less risky. Over longer periods, the stock market has historically delivered higher returns, but as the boilerplate disclaimer says, past performance doesn’t guarantee future results. The stock market can be volatile, and volatility can leave you susceptible to outsize losses in some assets.
Suppose you’ve assessed your objectives and risk tolerance and settled on a 50/50 mix of stocks and bonds. Figure 2 shows how a portfolio could become “unbalanced” over time if left alone. That’s why it’s important to consider a periodic rebalance of your portfolio to maintain your target asset allocation.
Note how the allocation mix changes over each five-year period. The 50/50 mix becomes 60/40, then 63/37. This imbalance creates higher risk in the portfolio, which translates to bigger fluctuations in its value by 2005. Subsequent market fluctuations cause the stock allocation to decrease to 60% by 2010 and increase again to 69% by 2015.
Note two key points here. The actual portfolio allocation at the end of the period is drastically different from the original 50/50 target allocation. And as the stock allocation increased, so did the risk of the overall portfolio.
How can an investor help keep this risk in check and maintain a long-term perspective? Consider conducting a portfolio review each quarter to determine if you need to rebalance your assets. Rebalancing simply means selling part of an asset that’s become overweighted. Those funds are then added to an underweighted asset, restoring your target allocations.
You can also address the risk and restore your target asset allocations by adding new money to a portfolio. For example, if you started with a 50% stock and 50% bond allocation, and it’s shifted to 60% stocks and 40% bonds, you could direct new money to bonds. Over time, the bond allocation should grow and come back into alignment with your 50/50 target allocation.
In the end, portfolio management comes down to risk management and patience. Remember, when it comes to your investments, compound interest and compound returns can be important allies. Putting your money to work as soon as possible gives it more time to grow, and to recover from any downturns along the way. For more information on the power of compounding, watch the video below.
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