The Glacier Effect: Power of Compounding

Compound return is the rate of return that represents the cumulative effect that a series of gains or losses has on an original amount of capital over time.¹ Compound returns encompass all types of income including interest, dividends, and capital gains.  This article will focus on compound return which is also known as “Compound Interest”, “Interest on Interest”, “Money making Money”, or “The 8th Wonder of the World”. Almost everyone and their dog has heard of this concept before in one name or another, and how important it is in creating wealth. But do we truly understand compound returns?

With that idea, I decided to put this blog piece together to discuss some of the reasons why compound returns can be difficult for us to understand.

Reason 1: Exponential, not Linear, Growth

Compound return relies on exponential growth.² When I say exponential, think of that as a rapid increase.

For investments, when return (the growth of the investment over a period) is added (compounded) to the principal of your initial investment, the subsequent return earned is based on this new, larger amount (principal + previous returns). This is where the term “Interest on Interest” comes from, as your principal investment and previous returns, such as interest, are working together to generate more return. This results in an extremely rapid increase, or exponential, growth of the investment over time. This growth can be difficult to visualize mentally, especially over long periods, as humans have an easier time thinking in a linear (straight-line) fashion.

Reason 2: Time Value of Money

At its core, the Time Value of Money (TVM) is the idea that a dollar today is worth more than a dollar a year from now. This is because a dollar today can earn money (return) if invested. An example of this is how a dollar 20 years ago could buy more goods than a dollar today, and how a dollar 50 years ago could buy more goods than a dollar 20 years ago. While inflation can show how one’s money is worth more now than in the future, applying that idea to one’s investments can be hard.

Understanding that money has different values at different points in time is a fundamental concept in finance. Compound return accentuates this idea by showing how money invested or borrowed today can grow or accumulate significantly over time through exponential growth.

Reason 3: Mathematical Complexity

While the concepts of exponential growth and Time Value of Money can be understood, the formulas used to calculate compound return involve exponents and continuous multiplication which can be daunting. When I was studying for my Chartered Financial Analyst (CFA) designation, I remember how I needed to write out, by hand, the increase in value of an investment for year 1, year 2, year 3, then multiply them together to find the final value of a compounding investment. After doing this multiple times the concept “clicked” but would require the use of a calculator.

For another example, if you ask me to add 7 six times (7+7+7+7+7+7 = 42) I would be able to do that math in my head. If you asked me to multiply 7 six times (7x7x7x7x7x7 = 117,649)³ I most likely would either answer incorrectly, need to have a calculator handy, or previously had memorized the answer before you asked me as a cool party trick to impress you.

Reason 4: Long Time Horizons

The true power of compound return is best seen over extended periods. Visualizing how a small amount of money can grow substantially over decades requires a good understanding of time frames and patience.

One of my favourite analogies of this comes from The Psychology of Money, written by Morgan Housel. He compared compound return to how a glacier forms. It starts with a small amount of snow surviving a cool summer. This snow makes it easier for future snow to accumulate during the following winter, creating greater odds of snow surviving the summer, and continuing the cycle. Over a small timescale, this cycle would not be very noticeable. But if you think of the Geologic Time Scale, the process can create glaciers that cover entire continents.

While I appreciate a good geology reference as much as the next person, I like this analogy since it’s easy to visualize. If you take a small amount of snow (money) and accumulate more snow (money generates return) over a long period of time, you can create a glacier (wealth). Time is the biggest influence on both glacier and wealth formation, so being able to think “long term” is important when it comes to compound return.

Reason 5: Application to the Real World

Compound return can be difficult for people to apply to real-life scenarios. There is no tangible application of it in our day-to-day life, except for in the financial realm. Even when thinking about investments and loans, factors like inflation, taxes, and varying interest rates must also be taken into account. These factors require significant brain power as is, then you throw in the concept of what the compounded return of the investment would be. This makes it much harder to understand and properly apply given the situation.

Reason 6: Psychological Factors

People, myself included, often have biases. Sometimes they are conscious and we know our blind spots, other times they are subconscious. When it comes to finance, these biases can make it challenging to be successful. Humans have a bias to think short term, so the ability to imagine a long-term goal such as starting at 19 to invest for retirement at 65 is harder for us than a short-term goal such as planning a meal for dinner. Also, we humans tend to think linearly or in sequence. We know May comes after the month of April, 8 comes after 7, and farmers plan crops in the spring to have full fields by fall. A lot of what we see and do happens in a sequence. These biases can lead us to focus on short-term investment performance or think that small investment contributions won’t make a big difference in the long term.

As we discussed earlier, these ideas are counterintuitive to what makes compound return successful; long time horizons and exponential growth. If an investor can overcome these biases by thinking long-term and starting where they are, no matter how small, they can utilize compound returns to their advantage. This can be seen with Ultra-High Net Worth Individuals, UHNWI, who are able to invest for the long term and understand the importance of compound return.

Hopefully this blog sheds light on some of the reasons why compound returns can be a difficult concept to grasp and has provided insights on how to get it working for you. No matter how small, the benefit of starting now and thinking long term cannot be understated. I believe Morgan Housel summed it up perfectly:

“If something compounds – if a little growth serves as the fuel for future growth – a small starting base can lead to results so extraordinary they seem to defy logic. It can be so logic-defying that you underestimate what’s possible, where growth comes from, and what it can lead to.” (P. 49, The Psychology of Money, 2020)

Until next time, start your snowball today for your glacier tomorrow.

Thank You,

Harrison Brown, B.Sc., CFA
Portfolio Manager
Alitis Investment Counsel Inc.