Understandably, investors tend to focus on the positive sides of compounding.
Yet just like the central figure in Robert Louis Stevenson’s 1886 classic novel Strange case of Dr Jekyll and Mr Hyde, compounding from a financial perspective has multiple, opposing characteristics.
The headline positive characteristic of compounding is 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 term. This is the Dr Jekyll, or good side, of compounding.
If you see a look of satisfaction on the face of some retirees, there’s a good chance that they are now enjoying the rewards of long-term compounding returns.
However, investors and consumers who ignore the negatives of compounding high investment management costs and compounding interest on debt are likely to pay a high price. This is the Mr Hyde, or bad side, of compounding.
In the prevailing low-interest investment environment with expectations for subdued returns over the medium-to-long term from diversified portfolios, investors can have even greater motivation to minimise their investment costs and to control their debts.
High investment management fees become particularly noticeable to investors when their returns are leaner. Nonetheless, investors might still overlook how high costs compound over time.
Investors should place a high priority on minimising their investment management costs whether they are investing in index funds, actively-managed funds or a combination of both.
And a good place to start minimising compounding consumer debt is with your credit card. Some disciplined cardholders, of course, pay off their entire bill each month to avoid any interest – let alone compounding interest debt.
Also, take a close look at your mortgage debt and the possibilities of gaining a lower rate and repaying the loan earlier than anticipated.
Don’t underestimate the potential full impact of compounding – good and bad – over the long term. Unfortunately, it is relatively easy to misjudge its cumulative effect on your finances.
