The powerful effects of compounding on bonds, mutual funds & ETFs

Einstein once said that 'Compound interest is the most powerful force in the universe'. Compounded returns are in fact extremely valuable for investors, but there are many incorrect 'wisdoms' in the market that seem to de-emphasize this force.

Why bonds are a sucker's investment

I will start off with a simple example of effective compounded interest can be. For some this will perhaps be uninteresting, but even to an analyst like me, the results were eye opening. We can assume that there are 2 investors in their mid 30s who do not expect to retire for another 30 years as of today. One investor is fairly conservative and invests half his pension in bonds and the other half in stocks. The other investor is considered 'aggressive' and invests 100% in stocks. The term 'aggressive' seems ridiculous to me since the investing period is 30 years, and I can guarantee anyone out there that over a 30 year period stocks will outperform bonds by a mile, but that is neither here or there.

In any case, let's assume that the 'careful' investor earns 8% on equities and 3% on bonds, while the equity investors earns 8% on his total equity portfolio. Care to guess by much the 'aggressive' investor will outperform? Well if both investors started with $10000 in their pension and never contributed anything else, the careful investor will end up with close to $50,000 which isn't too shabby. The aggressive investor will himself earn a bit over $100,000, an outperformance of 102% which is quite a large difference. The difference grows exponentially if the outperformance becomes greater (+3% ,+5%....), which could happen if a risk averse investor invests only in bonds for 30 years vs an all equity investor. In my example with arbitrary numbers, the equity investor would have earn more than 414% more or 4 times more than the lowly bond investor. We often  think of rates of return as having a linear impact on total returns, but they do not have a linear impact, and its one of those mathematical properties that we easily forget but one which is one of the most important tenets in finance.

From the chart below we can even see the massive difference between investing at 6% vs 10%, the difference is phenomenal and the better you are at investing, the more it compounds. Just imagine a 20% return which was earned in Berkshire Hathaway for close to 50 years!

This example is a rather a simple but it still expresses the power of compounding and the absurdity in buying bonds at young age for your retirement... And this is without considering that bonds are simply overpriced right now, but that is a completely different topic.

Why Mutual Funds are for suckers

Earning 8% is hard enough on the equity markets, so how our investors supposed to maximize their compounded earnings? One of the most obvious thing to do for investors is to stay the hell away from mutual funds. Ignoring individual stock picking which most investors are simply terrible at, investors also get burned by the idea that investing with a professional investment manager through mutual funds will benefit the investor. This is simply absurd. First of all, mutual funds managers after fees do not tend to beat the index market to which they compete against. And if they do it is usually because of luck, as almost no funds continuously beat their indices, the simple reason is fees. Many mutual funds will charge you 2% excluding front or back end costs, while most index trackers (ETF) will charge you 0.5% or lower a much more reasonable proposition. And as you can imagine from the Chart 1 above, it could make the difference between a 10% return and an 8% return.  

So again we are back to the power of compounding. If your ETF or the index earns 8% over 30 years, we can safely assume that the mutual fund will earn 7% (+0.5% outperformance before fees over the index, but a 1% underperformance due to fees). Over 30 years, from a $10,000 investment the ETF will end up with $100,626 while the mutual fund will end up at $76,122. Which means the investor would have lost out on 32% of returns, which would have gone directly to the 'professional investment manager', specifically giving him a fee of $24,504 for your initial $10,000 investment. Doesn't this sound completely ludicrous? And it goes without saying that the higher the fees, the greater the underperformance.

 So if I wish to pass little tidbits of financial wisdom it is this:

Never ever buy mutual funds, stay away from them like the plague. And if the fund manager was as good as the mutual fund salesperson will tout him to be, he would be a hedge fund manager.

Secondly, long term bonds are not always safe investments. In fact they are extremely unsafe investments currently, no matter what Mr. Standard Deviation will tell you. Because yields and bond values move on opposite directions are, any rise in interest rates will punish bond prices. And if you consider that bond prices are sky high because interest rates are artificially low right now, there is nowhere to go but down for bonds. You can try to bank on further interest cuts but 0 is still 0, and they do not much room to move down, but they have plenty of room to move up.

If you look at the equity earnings yield (inverse of P/E ratio) and the spread between corporate rates, they have never been as high in the past 20 years (see Chart 2). This is a very bearish signal for bonds and a bullish one for equities, as it appears that equities are cheap relative to bonds. 

I can not predict when the bond rally will stop, but be sure that 'the chicken is coming home to roost' and equities will outperform in the next 10, 20, 30 year periods no matter what doomsayers are spewing.