It has been said that compound interest is the most powerful force in the universe. This mathematical concept is talked about often in investment circles, and even had its magnificent power famously declared by Albert Einstein (albeit the scientist’s actual words are still debated). Without doubt, compound interest has its place as a force to be understood, respected, and utilized. Yet, those with perspective know and admonish that compounding interest actually pales when compared to its stronger alter ego.
As an occasional optimist, I can understand the fascination — from many a perspective, compound interest shows its muscle daily for the benefit of investors, financial officers, economies, and even history. However, the realist in me cannot overlook the ofttimes-shortsighted perspective from which we too commonly view it. We forget, sometimes very regrettably, of the other mathematical force even more powerful — “negative compounding” (or a negative rate of return.)
Losing money not only hurts emotionally, it is devastating to the long-term value of an asset or portfolio. Drawdowns (i.e. large loss of value from market or asset depreciation) create results that are drastically more profound than that of positive compound interest. A portfolio that loses 10% needs to make over 11% to get back to par. That which loses 20% must muster gains of 25% to reach even. A 30% drop needs almost 43% to make up loses. And so on…
Many investors get caught-up in the hot stock, hot trend, or hot investment manager. We all hear about the new best pick or best performing investment advisor. In an up market, this happens often. And, let’s remember, in a good market these hot picks have compound interest on their side, making them seem even better as investments pay and appreciate. But failure to recognize the significance of drawdowns (i.e. “negative compounding”) is an oversight you cannot afford to make.
As markets move one way or another and you look to “make money”, certainly remember the power of compound interest. And, for the betterment of your investments and portfolio, never forget the most powerful force in the universe — negative compounding.
Jonathan Citrin is founder and CEO of CitrinGroup, an investment advisory firm located in Birmingham, MI. He is an adjunct faculty of finance in the School of Business at Wayne State University.
Founded in 2003, CitrinGroup specializes in portfolio management and advises clients on investment planning.
Contact: 248-569-1100 or www.citringroup.com or firstname.lastname@example.org.