Welcome to Secrets from the Vault: our comprehensive guide to everything you need to know to invest with confidence. Featuring insights from the experts at Union Bancaire Privée, each month we’ll be bringing you a digestible overview of the most important trends, techniques and need-to-know terms for maximising your portfolio, aiming to explore the current investment landscape, educate readers, debunk myths, demystify financial concepts, and provide valuable insights into investment strategies. First up, senior investment manager Olivia Jackson on the wonders of compound returns…

When it comes to investing, we often hear familiar phrases such as “time in the market, not timing the market”, “building wealth, not chasing it” and “investing is a marathon, not a sprint”. While these messages are simplistic in nature, beneath the surface they convey the same core idea: the value of staying invested and harnessing the power of compound returns.

Understanding these concepts is essential for anyone starting their investment journey, making it the perfect place to begin Secrets from the Vault.

Compounding: The 8th Wonder of the World

“Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.” Albert Einstein

In simple terms, ‘compound return’ refers to the process where the investor receives a return on the original investment and, in addition, on all previously accumulated returns – the ‘return on the return’. Over time, this can create a snowball effect allowing investors to benefit from the compounding return year on year.

As an example, imagine you invest £1,000 today expecting to achieve a stable annual return of 5%. After the first year, you would gain £50 (5% of £1,000). In the second year, the value of your portfolio is £1,050 so you would gain £52.50 (5% of £1,050). This effect continues to compound with 
each passing year. The longer you stay invested, the more powerful the effect becomes.

What style of investing can erode compound returns?

Return Dispersion: The journey the performance of an asset takes is important for maximising the compounding effect. The effect is negatively impacted when returns are significantly varied from year to year. The below example shows three paths of returns, ranging from stable to highly dispersed over three years, and all three have an average annual return of 5%. While investors may be attracted to the higher returns in years one and two, for the highly dispersed asset the total return over three years illustrates how this path meaningfully underperformed the more stable path by more than 5%. What this tells us is that even if there are multiple years with very high returns, a stable return provides the highest return because of the compounding effect.

Constructing your portfolio

Diversification and uncorrelated assets can be used to reduce dispersion. By including multiple asset types (equities, bonds, gold, etc.) in a portfolio that react to developments in markets differently (diversification), the dispersion of the overall portfolio can be controlled and limited. Monitoring the level of uncorrelated assets in a portfolio throughout different periods in business cycles is essential to dampening volatility – thus promoting the power of compounding returns. This serves as an important reminder that, while returns of +20% on investments such as single concentrated stock holdings can be tempting, they usually come with higher levels of volatility, potential damage to long-term returns and legacy wealth.

Understanding Negative Returns

Downside risk management and capital preservation is crucial for maximising compounding returns. During periods of market downturn, such as a global pandemic or a global bank failure crisis, multi-asset investment portfolios are expected to experience negative returns. This ‘drawdown’ negatively affects compounding, and the key is to controlling and managing this.

For instance, if a £1,000,000 portfolio drops 5% to £950,000, it needs a 5.26% return next year to recover. Larger drawdowns require even higher subsequent returns. A 20% drop necessitates a 25% gain to return to £1,000,000 – a challenging hurdle.

Incorporating compound returns into your investment plan

We can use certain investment strategies and tools that can provide a level of downside protection, capital preservation and reduced risk levels to reduce negative returns. Including assets in an investment portfolio that may typically experience lower levels of drawdown and dialling these assets up during periods of heightened market uncertainty is fundamental to capital preservation and maximising the power of compounding.

Compounding returns can be optimised through construction and management of investment portfolios that offer defensive characteristics in times of market distress (less negative returns) and adequate diversification to reduce volatility (less dispersion) at all times. By limiting losses and overall fluctuations, the portfolio requires less recovery to reach previous levels. This style of investing can help preserve and enhance long-term compound returns.

If you have any questions about this article or would like to start a conversation about wealth management with a UBP (UK) investment professional get in touch at [email protected].

Read more: How to manage a large financial windfall

This article is provided for information purposes and is not investment advice or a recommendation.

Information in this document is believed to be reliable but Union Bancaire Privée (UK) Limited does not guarantee its completeness or accuracy, and it should not be relied on or acted upon without further verification. Investments may be subject to market fluctuations and the price and value of investments, and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount originally invested. Changes in inflation, interest rates and the rate of exchange may have an adverse effect on the value, price and income of investments.

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