Compound Interest in a Low Yield World
When the undercarriage of conventional wisdom is swapped out, but we carry on as though nothing has changed
I’m a fan of Scott Galloway, and I recommend you read his post on The Algebra of Wealth, but I take issue with one particular topic when he discusses wealth: compound interest. He’s particularly fond of mentioning this:
The gangster authority on time, Albert Einstein, supposedly remarked that compound interest is the eighth wonder of the world.
Compound interest is in fact a powerful wealth builder. I remember in school having to do calculations to show how much money you would need to save with interest to become a millionaire. As an 11 year old, we were to be wowed by the prospect of one-million dollars (still a lot of money, but feels somewhat diluted as we’re now told this is not nearly enough for a proper retirement). It was used as a lesson to show how small savings over time add up big in the long run. Here’s a lesson from Dave Ramsey that is nearly identical to the one I was taught.
The Ramsey article is from 2020 and it differs in one crucial way from my school lesson in the 1990s. Ramsey refers to investing whereas in school I was taught about saving. We did the calculations with a 7% interest rate and assumed it was money in a savings account. Now we get the same lesson, but the source of the return has been swapped from bank deposits to investing. I wish there was a word for when the undercarriage of conventional wisdom is swapped out, but we carry on as though nothing has changed. Galloway’s concern about the poor financial prospects of younger generations is clear in his work, so I find it out of place that he’s content to sing the praises of compound interest while glossing over this major change.
Saving has been taken away from you, but it’s not talked about because there’s a replacement: passive investing. You’ve likely heard this fact about the S&P 500:
The index has returned a historic annualized average return of around 10% since its inception through 2019.
So why am I complaining? Put your money in a lost cost index fund and you’ll still be a millionaire. It so happens that the growth of passive investing explodes as interest rates have fallen. In the first graph in the linked article you can see passive investing hockey stick from 2008 onward. It comes down to a key phrase you’ve likely seen many times but mostly ignored: “Past performance is no guarantee of future results.” If you buy a CD you know the yield at maturity, and it’s even insured against loss. No financial institution will make such a claim about an ETF, and in truth no one knows each year’s rate of return on the stock market. We’re supposed to accept as a matter of faith that among the positive and negative years, over time it adds up a particular return.
Compounding through investing relies on infinite time horizons in a way that saving does not. In retirement there’s the “own your age in bonds” rule of thumb to protect against retiring during a recession, but in an environment with such low interest rates that means forgoing compounding interest in the name of capital preservation. Many pension funds assume 7% as their annual average rate of return. High quality corporate debt yields about 3% right now, treasuries even less. If you’re getting that hypothetical 10% return on your index funds but following the aged based bond/equity allocation rule, you drop below the 7% return rate after you turn 43 (43% bonds 57% equities). For comparison at a 2% bond yield you drop below 7% at 38. For you to make it to 65 without dropping below 7% average return, the bond yield would have to stay above 5.4%.
People aren’t marching in the streets because we’ve had a pretty powerful bull market for equities since 2008. Just as the average person came to hold passive vehicles, outside of a few episodes of turbulence, the performance has been steady, positive, and exceeding the compound returns of a bank account with a good APY. As we’ve switched our compound interest narrative from saving to investing, index funds have presented as good substitutes hiding from us what we’ve lost. But what happens if we get a stretch like we had from 2000 to 2002 where for three years in a row the return on the S&P was negative? In 2001, passive vehicles accounted for about 10% of all funds invested in mutual funds and ETFs. Its share now is closer to 50%.
Intellectually people know that ETFs aren’t bank accounts, but haven’t had to grapple the reality of a bear market. I’m not making a specific prediction of a market crash or commenting on whether the current rise in equities is a bubble. What I am doing is highlighting the structural fragility in our system caused by the annihilation of risk free return from our saving and investing landscape. I’m not the first to make this point, but I think it should be front and center whenever we discuss compound interest. If a multi-year bear market feels impossible to you (stonks only go up), part of the reason is because it is unthinkable given our current structure. Such an event would be so profoundly dislocating for people (in a way previous bear markets were not), it is no secret policy makers in many countries are specifically doing what they can to prevent it.
In summary, a massive structural change has occurred. It’s worked out okay so far so we don’t really discuss it, but it’s non-obvious that will be the case forever. Smarter people than me have more to say on this topic, Christopher Cole and Mike Green just to name a few.