Plenty of "noise" was created in investment markets on Budget day that had nothing to do with the anything in the Budget.
This extra noise was triggered, of course, by the cutting of the official cash rate to a new record low of 1.75 per cent on Budget day and by the local sharemarket rising in response.
Avoiding being distracted by market noise is critical in order for investors to remain focused in a low-interest investment environment that the 2016 Vanguard Economic and Investment Outlook expects will become more challenging and volatile. And Vanguard’s report emphasises that investors who can remain patient, disciplined and appropriately diversified are likely to be rewarded over the next decade with "fair inflation-adjusted returns".
It is timely to revisit one of investment’s most-effective noise-blockers: the potentially-awesome power of compounding returns.
The headline attributes of compounding are that investors earn investment returns on past investment returns as well as on their original capital. And the compounding returns can really mount (or compound) over the long haul.
However, a perhaps understated reward of compounding returns is that investors who are in a position to reinvest their earnings into carefully-diversified portfolios are less likely to be distracted from their long-term course by the latest market noise.
Approaches to get the most out of compounding include:
- Starting to invest as early as possible with as much as possible. Compounding needs plenty of time to produce its best results.
- Investing regularly to keep building the investment capital for compounding to work what has been described as its "magic".
- Sticking to an appropriate long-term asset allocation for your portfolio – including having enough exposure to growth assets.
Super fund members in the accumulation phase provide an excellent illustration of compounding returns over the very long term. From the time that members first join a super fund at a young age, their continually-reinvested returns are compounding – a process that can accelerated by making voluntary contributions in addition to super guarantee amounts.
Vanguard founder Jack Bogle in his discussions about the rewards of compounding returns contrasts them to the destructiveness of what he terms "compounding costs" of high investment management fees.
His point is that the damaging impact of high annual fees keep compounding over time to erode the benefits of compounding returns. In other words, they work in opposite directions.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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