Compounding of equity returns – the greatest fallacy in financial planning

In several of my blog posts I have written about the frequent wrong usage of Maths to create misconceptions in investing which are not factually true. One such glaring misconception is for investors to feel that there will be compounding returns on equity investments, at least over the long term. This is simply not true and I would have thought that most investors would be able to understand this. However, as I have got quite a few queries and requests for clarification, let me do so here.

To start with let us fundamentally understand what Compounding is. I have used the following definition from Investopedia:-

DEFINITION of ‘Compounding’

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Essentially compounding involves some positive return on your asset, irrespective of what the return might be. Due to this the absolute value of your investment will always be increasing. Note here that we are not talking of inflation and Real returns here. For example, if I have a FD of 1 lac Rs and it pays me an interest of 8 % today then at the end of 1 year I will have an amount of 1.08 Lacs. Now if inflation is also at 8 %, my real return ( interest rate – inflation rate) is 0 and I have not really gained anything in terms of my purchasing power through this investment. At the same time, the absolute value of my investment has definitely grown by 8000 Rs in the one year period. This 1.08 lacs becomes my principal amount in the next year and I earn interest on this new amount. So in effect, compounding entails my earning interest not only on the principal amount but also on the interest amount.

The usage of compounding logic works great with debt products where the interest rates are relatively stable. Take an FD as an example again. At 8 % interest rate your money will double in approximately 9 years, at 12 % rate it will double in approximately 6 years and so on. Your money always grows in absolute terms, ignore the real growth for this discussion.

Now let us look at equities and see if this logic can be sustained in the light of our knowledge of it. If you look at stock prices over a period of time, you will see that it is clearly not so. Let me give you some examples from well known companies and their share prices from fairly recent memory:-

  • ITC reached 400 Rs and is now down to 300 odd levels.
  • Tata Motors went to 600 and then declined to levels of 250.
  • Reliance has had negative growth over years, so has Tata Steel.
  • Some company shares like Kingfisher Airlines and Gitanjali Gems have become penny stocks today.

There are also many examples of company shares having done extremely well and generate spectacular returns. My point here is simple – equities can give great growth but the way to understand that is not through the compounding principle. The growth in equity is non-linear and carries serious risk with it. Now at this point, people may tell you that over the long term of 15-20 years the compounding logic will hold true for equities. Sorry, it does not – if you bought the shares of Deccan Aviation at 146 Rs in the IPO , you have lost this money pretty much forever, never mind how long you are going to wait.

When I think about why there is such a great misconception about something really straightforward, I could come up with the following reasoning in my mind:-

  1. Most people invest in equity through Mutual Funds. As a MF scheme maintains a portfolio of stocks, the overall NAV of the scheme would normally increase in a reasonably good market, which we have had in recent years. If you take the mid cap and small cap funds in 2018, you will see the extent of loss that your schemes have suffered.
  2. Of course, the above can change in a prolonged poor market, but not many of today’s investors have had this experience. 2008 through 2010 was such a phase but has been mostly forgotten now. That is why many investors are shocked in 2018 when the NAV’s  of their Mutual fund schemes went south in a big way.
  3. The usage of CAGR term, somehow makes one think that equity investments compound. This, of course, is complete nonsense but I have seen many sensible people believe this. CAGR is an artificial construct to understand annual returns, it in no way says that such returns are stable and not even that they are positive. In fact you can have negative CAGR and negative IRR / XIRR quite easily.

So, if it is clear by now that compounding logic is irrelevant to equities then how do we go about financial planning with equities as an investment asset class? I will answer that in a future post. For now, do understand that you cannot just hope that you will invest in stocks and it will give you an XIRR of 15-20 % because that has been the historical returns in the index. I really wish life were that simple for me and you, but it does not work like that.

Take heart though – we can make great returns from equity, by understanding the correct ways of investing in it.

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4 thoughts on “Compounding of equity returns – the greatest fallacy in financial planning

  1. Hi Rajshekar.. Have been following your post quite regularly. for people who have been investing and tracking their investments -with the recent surge in indices- would you recommend booking profits

    Like

  2. Dear Sir,
    I am a regular reader of your blog. Thanks for your time which enlighten so many people around.
    I always find it difficult to invest a Lumpsum amount in the Equity MF. I know it is difficult to time the market but considering today’s scenario where market PE is very high I am very scared to enter with Lumpsum in the market. Hence I am sitting on my cash. Now as market is moving towards north I always feel have I just missed the market rally and will get chance to enter or not in other words my patient is under test for a very long period.
    Can you please guide me in this regards i.e. What could be the strategy for Lumpsum investing ? What market parameters we should check for this ?
    This would be good help to me.
    Regards, PARTH Shah +91 9511775857

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    • Hi Parth,
      Thank you for your nice words !! One way for you will be to look at close ended funds which are available through NFO. The criteria for investment can be decided through the DMA approach.
      There are quite a few posts in my blog on this – read them and you will be able to find out a way for yourself. In case you need further inputs or guidance feel free to check with me.

      Thanks
      Raj

      Like

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