Thursday, September 1, 2016

Beware The Dark Side Of Compounding

This is going back to the basics 101.

All of us are aware why compounding is one of the wonders of the world. 

By now, most investors would have known the effect of compounding over time and how they can exponentially grow their wealth to incredible amount, if done correctly. 

Compounding returns which are positive year after year feels great, especially in an environment where the market allows us to do so. But too often we get attached to statistics and numbers and thereafter starts to erode our euphoric emotions that allow us to somewhat extrapolate the same returns over the next 40 years. Is that realistic?

This is exactly how insurance agent attempts to sell product because it just looks too attractive 40 years down the road and often folks fell for such thing.




Dark Side Of Negative Compounding

The dark side of compounding is often neglected as folks tend to focus towards the part on success and brushed aside the part on failure. 

Negative compounding - a reversal concept of the dark evil side of compounding.

This type of compounding can play a big part in slowing down and to a large extent destroy our attempt to grow our wealth. 

Credit card charges is one of most immediate example I can think of that applies in our daily lives.

While there are benefits associated with it, it charges exorbitant interest rates for folks who fail to pay the charges on time. The interest amount may be minuscule and ridiculed at the beginning but over time it can add up to quite a substantial amount.

The same goes for folks who invest in the stock market thinking they can earn a decent 3 - 4% over the next 40 years.

The truth is there are many who lost money in the stock market and erode their wealth over time. To put it simply, these group of people are probably not ready and would be better off growing their wealth via other means.

The next time you get excited over compounding, think of what it can do on the reverse. Beware on the dark side of compounding.

11 comments:

  1. "The same goes for folks who invest in the stock market thinking they can earn a decent 3 - 4% over the next 40 years.

    The truth is there are many who lost money in the stock market and erode their wealth over time."

    What do you mean? Picking the wrong stocks?

    ReplyDelete
    Replies
    1. Hi Bapu

      Yeah we are all still susceptible to making mistakes in the stock market.

      Delete
  2. Not every stock is a winner. There are some in my stock portfolio that has been on downtrend for a few years already like Far East Hospitality Trust.

    ReplyDelete
    Replies
    1. Hahaha at least FEHT is giving a pretty good yield to get by

      Delete
  3. Hi B,
    Yah! The past events or return does not guarantee that you will get the same result. .that was not being emphasized most of the case when we buy insurance products or unit trusts. .
    Cheers! !

    ReplyDelete
    Replies
    1. Hi STE

      Thanks for reminding us again that past event does not correlate into future returns.

      Delete
  4. Hi B,
    Yah! The past events or return does not guarantee that you will get the same result. .that was not being emphasized most of the case when we buy insurance products or unit trusts. .
    Cheers! !

    ReplyDelete
  5. You know I used to think index ETFs would be okay, at least cover inflation long term.
    Just checked my emerging markets ETF(IEMG), it has a net 0 gain today if I had invested 5 years ago. So yes, DCA would have been better, but still sad.

    ReplyDelete
    Replies
    1. Hi Anonymous

      I think for that you need to take almost an infinity type of lifetime long term in order to see the benefits. It's hard to quantify indefinitely over 5 or 10 years and even that the entry and exit point might be during different circumstances.

      Delete
  6. Those CPF members who are investing their CPFIS will know the true meaning of compounding interest on their CPF interests and compounding return in their CPFIS portfolio.

    Ask those senior citizens who were active CPF investors before 1997/1998 AFC.

    ReplyDelete
    Replies
    1. Those were scary times indeed. Many were scarred big time..

      Delete

UA-57154194-1