For years, investors have been told a myth of sorts. That if they leave their money invested in the market, compounding will work it’s magic. Unfortunately, the experts left our part of the equation - which we’ll get to shortly. Compounding, a concept largely derived from how cash sitting in a bank grows, does not work the same way. Per Investopedia.com
Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same time period.
The KEY: COMPOUNDING only works for you if you avoid DRAWDOWNS!
The table to the left compares two different but similar scenarios. In scenario 1, two years of 10% gains are followed by a 10% loss and the pattern is repeated. In scenario 2, money compounds at a consistent rate of return (3.3%)
What you will notice is that scenario 2 is the winner. The tortoise beat the hare. In scenario 2, despite modest returns, the principal has grown 21.72% (in 6 years) and in the other example, despite there being 4 of 6 years at a 10% return, the unlucky investor would have less money. Scenario 2 has no drawdowns!
The moral of the story is what many investors miss! Scenario 2 is better. Compounding is working. Slower growth is winning because big drawdowns are being avoided. This is how compounding works!
That's just the way it works!