Negative compounding returns

Submitted by HopefulInformation t3_z6nisc in personalfinance

Hello I was reading an investorpedja article on negative compounding. It says that during market declines when portfolio drops, compounding works against you. And because of that your returns don’t really end up being “10% per year on average” as you need to make a higher return to get back to normal than the drop. So you compounded annual rate would be like 9.4% or 7.3% depending on the variance of the drop.

I’m just confused. Everyone like buffet says passively invest in index like sp500. And we use these online retirement calculators that says use a 8-10% return on average for sp500 over 30 years. But the compounded return is less depending on the size of market crashes.

The article said only way to avoid this is to basically time the market or value investing by picking stocks which also has their own risks.

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DeluxeXL t1_iy2c511 wrote

It's just how we present gains and losses. We don't include the 1.00 (100%) and only show the change (e.g. x90% is written as -10%, x110% is written as +10%). The geometric mean is still the same once the full form is written out.

> And because of that your returns don’t really end up being “10% per year on average”

Actually, they do. 10-year CAGR of S&P 500 is around 10-12% before inflation adjustment, so the "you need to make a higher return" is already factored in. Higher return aka market recovery comes unpredictably. The real trick is to not miss the recovery by staying invested during a decline.

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HopefulInformation OP t1_iy2djzt wrote

That makes sense. Thank you!

Link to article here: https://www.investopedia.com/articles/06/compoundingdarkside.asp

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DeluxeXL t1_iy2flfo wrote

Bad advices in the article. Author recommends stock picking and market timing.

> Investors must become good stock pickers rather than just investing in a diversified portfolio of stocks.

> Another strategy is to use bonds to build a ladder that provides a relatively safe return that can be used in a weak stock market environment.

> it is even more important to employ proven capital management techniques. This starts with trailing stops to minimize losses and/or capture some profit from an investment.

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Mysunsai t1_iy2ccef wrote

The long term average return of the stock market as a whole is around 10% annually. This includes any effects of compounding you choose to name, whether you want to call them “negative” or “positive” or any other label.

That return is a long term average over more than 30 years, any particular year (or 2 years, or 5 years, or 10 years) is quite unlikely to be exactly 10%. Some periods are higher, some are lower.

It is perfectly true that a drop of 50% requires a gain of 100% to break even. But that doesn’t mean anything new or interesting, long term market return calculations already include all price changes by definition, including both the 50% loss and the 100% gain.

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HopefulInformation OP t1_iy2dosi wrote

Thank you. Here’s the link: https://www.investopedia.com/articles/06/compoundingdarkside.asp.

It talked about the DJI and how instead of it being a 10% return it was much lower compounded growth

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Mysunsai t1_iy2f8z0 wrote

It’s true that “average returns” are not particularly interesting to look at, and do not take into account the effects of compounding.

That’s also both irrelevant and highly misleading, since when people actually talk about stock market returns, they are using average annual growth rate (also known as compound annual growth rate), not average returns. That’s what the 10% number commonly discussed is.

And that number is also the stock market as a whole weighted by market cap, not the DJIA which is 30 companies weighted by stock price.

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KoastPhire t1_iy2c9y1 wrote

Without reading the article I think they're saying something like this:

If you invested $100 and it dropped 10% it becomes $90 and if next year it went up 10%, you'll be at $99. Some people would say that is a wash in percentage growth but overall you're down $1.

Timing the market never works so your second best option is to be consistent and invest over time.

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jackstraw97 t1_iy2fdh9 wrote

Timing the market is impossible so the next best thing is to keep money in the market for the long haul. It’s not a sprint.

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ChiSquare1963 t1_iy2fewm wrote

Consistent long-term investing in a diversified stock fund averages about 10% return. Consistent is essential, adding money when market is down as well as up. Long-term means 30-40 years.

Over short and medium term, returns vary. You really need a long horizon for stock funds to recover from major declines.

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kveggie1 t1_iy328e8 wrote

if one invests in index mutual funds for the long term, then this article does not matter at all.

If you are in the accumulating phase, and the market is down, you have a great advantage, because you are buying the index funds when they are on sale basically.

I would forget about that article.

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SlateWadeWilson t1_iy3gw38 wrote

I'm personally pretty conservative. So when I play around with 401K calculators and similar tools, I assume a 4% average annual return and plan to invest accordingly.

It's possible, even likely, that I'll be pleasantly surprised with more money in retirement than I'd planned on. But my strategy leads to a much greater level of stability.

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HopefulInformation OP t1_iy3hj6d wrote

What percent do you use to factor in inflation? 3% so 4-3=1% inflation adjusted growth? Lol. I try to assume a smaller return too on the calculator bc you never know

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SlateWadeWilson t1_iy3hrcq wrote

I kind of just get curious to see where I'm at and where I'm going every four months or so. And the calculators I use all claim to account for inflation automatically. I don't know what percent they use to account for inflation though.

I assume they don't account for black swan-type events like COVID+the CARES Act though. That's a big part of why I figure no better than 4%

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shadracko t1_iy2c8t6 wrote

Link to article if you want feedback. But safe to say you can ignore the article and follow standard PF advice.

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HopefulInformation OP t1_iy2diif wrote

here

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MarcableFluke t1_iy2qw8t wrote

Terrible article.

The stock market doesn't compound. Stock prices go up and down at unspecific percentages. When someone says the stock market goes up by 10% per year, what they're really saying is "looking at historical trends of the market, we see that a $100 investment over the last 30 years would yield a current value of $1745 today. We can then use a compound interest formula to equate that to 10% growth per year, compounded annually".

We're choosing a formula and plugging in numbers to find a percentage that makes sense to us. The market isn't actually growing through compounding formulas, that's just what we're using to describe the growth.

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