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A 'wonder of the world' loses some lustre

19 January 2017


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Commentary by Peter Westaway, chief economist and head of investment strategy, Vanguard Europe.

Most of us remember learning to compound. We might have enjoyed its mathematical elegance. We might have felt the pain of a calculation requiring square roots. It might have occurred to us that making money from money was a particularly smart idea.

Whatever the response, it was at least obvious that compounding has a practical application. You didn't actually need to do the maths. No lesser light than Albert Einstein called compounding the eighth wonder of the world, explaining that, "He who understands it, earns it ... he who doesn't, pays it."

Now, it goes without saying that we need to tread with care when it comes to questioning Einstein, but in a world where interest rates are 0.25% a year, does compounding retain its force? Or is it time to seek an alternative?

Before we start to play with numbers, we should remind ourselves of just what we're doing when we 'save' money. In putting money into a bank – even a simple, on-demand deposit account – we are effectively lending our capital to that institution.

The bank does not keep our cash in a vault. It aggregates its deposits and lends them at term in the form of car finance, home mortgages and business loans. In other words, someone else is enjoying the use of our money to drive about in a slick car, or to live in a nice house, or to build up a profitable business.

Compounding is the magic ingredient. The borrower is motivated to repay the loan in order to avoid the effects of compounding, having to pay interest on interest and risking a spiral of debt. We, the lender, are motivated to keep lending, or to keep our money in the bank, in order to benefit from the effects of compounding, receiving interest on our interest, our capital accumulating without further effort.

But at 0.25% interest, does the 'wonder of the world' retain its force? Does the system still work?

Let's do the maths

As an example, let's say you put £10,000 into a deposit account, with 0.25% interest, accrued daily and paid, and therefore compounded, annually. This is fairly typical of high street deposit accounts. After ten years, you would have received £252.83 in interest. Almost all of this, £250, is the simple interest, that is, interest before compounding. The total effect of compounding – the interest paid on interest – is £2.83.

At 0.25% interest, the power of compounding dissipates

Total interest paid on interest over ten years on a principal of £10,000 is only £2.83.

Source: Vanguard. Illustration only.

It is a staggeringly small amount. It is telling us that at current interest rates, saving in the traditional sense, as a means to accumulate capital, is redundant. Banks may continue to play a role in cash management and treasury functions, but the eighth wonder of the world has lost its wonder.

The alternative

Fortunately, there is an alternative. It is investment. At heart, investment and saving are very similar. At their simplest, they are both ways to transfer capital from those who have it, and want to earn something from it, to those who can make use of it and who are willing to pay for it.

There are four critical differences. One is the mechanics. As we have seen, with saving the intermediation is through banks. In investment, it goes through financial markets, such as the London Stock Exchange. Some people like to access the market directly through a stock broker, but many, probably most, are more likely to prefer to use some form of mutual fund.

The second is cost. Opening and accessing a deposit account is generally free of any charges. Stock brokers charge transaction fees and mutual funds charge fees for management, custody and other services, some of which can be levied in advance, some annually and some on redemption.

The third is risk. The UK government offers a strong guarantee on bank deposits. Investment carries no guarantee, and investors can end up with less than they put in.

The fourth is returns. The returns on a deposit account are predictable, even when low. The value of cash may erode through inflation, but interest rates tend to reflect inflationary expectations and to steady them. Investment returns are unpredictable and changeable, though the degree will vary depending on the type of investment.

The returns on invested capital, however, have the potential to be much larger than those on saving. Due to their unpredictability, we can't just 'do the maths' and work out what those returns will be, and we need to be just as careful, for the same reason, looking backwards. Past performance is not an indication of future returns.

Bearing these caveats in mind, if we look at United States equities, in sterling, net of fees and taxes, we see that in the five years to end-September 2016, the total return in the Vanguard US Equity Index Fund was 150%. On the same basis, UK equities returned 82% and European equities, excluding the UK, 68%. Again on the same basis, global bonds returned 24%, a return diminished due to the fall in sterling relative to the dollar and the euro.

Five-year cumulative returns
Total return in sterling on a £10,000 investment in Vanguard UK-domiciled index funds, net of fees and taxes, with income reinvested.

Source: Factset. See the table below for 12-month returns on the Vanguard funds on which this illustration is based.

Returns in the next five years may be very different. But if we look at the behaviour of different types of investment assets over the very long term, we can identify more persistent characteristics. In the 115 years from 1900 to 2015, for example, UK equities typically averaged a return of 9.1%, while UK government bond returns have averaged 5%.

Again, these returns are not to be relied upon for any particular period, but they offer an indication of the potential behaviours of the two main types of financial investment, equities and bonds. The key consideration is that investment is a long-term commitment. We are only likely to reap the benefits through maintaining a balanced portfolio over a period of time.

What, though, should we conclude about saving and investment? In our view, we would be better off dropping the distinction and thinking of cash, equities and bonds as three elements in a well-balanced portfolio of financial assets. The cash portion offers liquidity, the equities capital growth and bonds and element of income combined with a steadying ballast.

12-month returns
Total return in sterling, net of fees and taxes, with income reinvested, for the Vanguard index funds referenced in the illustration above.

Period

Vanguard Emerging Markets Stock Index Fund

Vanguard Global Bond Index Fund

Vanguard FTSE UK All Share Index Unit Trust

Vanguard FTSE Developed Europe ex-UK Equity Index Fund

Vanguard US Equity Index Fund

Vanguard LifeStrategy 60% Equity Fund

1/10/2011 to 30/9/2012

12.52%

5.75%

12.20%

16.41%

10.71%

9.29%

1/10/2012 to 30/9/2013

-4.63

-0.13

20.79

25.68

30.27

11.13

1/10/2013 to 30/9/2014

3.49

7.97

1.05

-0.39

18.95

9.36

1/10/2014 to 30/9/2015

-10.04

1.25

0.89

5.69

5.93

2.53

1/10/2015 to 30/9/2016

31.32

6.52

12.28

13.84

22.37

15.51

Source: Factset.

Past performance is not a guide to future returns.

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