(866)-482-2177

sales@alphatheory.com

REQUEST A DEMO

SYSTEM REQUIREMENTS


Please note the following System Requirements. Further, please limit the number of open applications (particularly price streaming applications) while logged in to Alpha Theory™.


Recommended System Specifications
Processor: Dual Core or Quad-Core 2.4GHz or faster
RAM: 4GB+
Browser: Google Chrome 30+
Screen Resolution: 1280 x 1024 or greater
Internet Access: Business Class High-Speed


Minimum System Requirements
Processor: Intel Pentium-M 2.0Ghz or equivalent
RAM: 2GB+
Browser: Google Chrome, Mozilla Firefox, Internet Explorer 9+ (without Compatibility View), Safari
Screen Resolution: 1024 x 768 or greater
Internet Access: High-Speed

Subscribe to Alpha Theory content

Alpha Theory Blog - News and Insights

« July 2021 | Main

1 posts from August 2021

August 31, 2021

Caveats in Compounding

 

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

 

“Compounding is the most powerful force in the universe” – Albert Einstein

 

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett

 

Compounding really is the 8th Wonder of the World. In a recent analysis, we were comparing the CAGR (Compound Annual Growth Rate) of two portfolios and noticed two unique qualities of compounding that are important to remember when using CAGR:

 

1. Small differences in CAGR can compound to large differences over time

2. A 1% difference in two small CAGRs is not the same as a 1% difference in two large CAGRs

 

Small differences in CAGR can compound to large differences over time

 

Imagine you have two portfolios. One generating 8% per year and another 9%. The 1% difference seems trivial. Because of compounding, it is not.

 

Screen Shot 2021-08-31 at 3.19.42 PM

 

The 10-year performance difference is a non-trivial 20.8%. This means that finding investments that may seem marginally different when compared at the small scale of a year, can have profound differences over time.

 

One interesting fact was that the total difference over ten years was 20.8%, which is not the same as the 1% difference compounded over 10 years, which is 10.5%. This leads to the second unique quality…

 

A 1% difference in two small CAGRs is not the same as a 1% difference in two large CAGRs

 

If we bump the performance slightly up but keep the difference 1%, the total difference grows from 20.8% to 22.6%.

 

Screen Shot 2021-08-31 at 3.19.51 PM

 

That 1% difference gets to compound a bigger base and thus results in a larger total return difference. This is counterintuitive. An investor may be indifferent between a 23% and a 24% return while being sensitive to a 2% versus 3% return. The later seems much more meaningful because the relative difference is 50%.

 

In the graph below, the difference between a 2% and 3% return is $12.5M (12.5% on $100M fund) over 10 years. The difference between a 23% and 24% return is $62.1M! They are both 1% differences, but they are not created equal.

 

Screen Shot 2021-08-31 at 3.21.54 PM

 

Compounding is amazing but can be amazingly difficult to conceptualize. As an investor, your job is to be a professional compounder. Keep your tools sharp by remembering that CAGRs don’t tell the whole story. To get a better sense of the return stream, compare the CAGR to the total return for a period of time and then perform some basic sensitivity analysis. This allows the compounding impact on returns to present itself in a way that is easier to put into perspective and help you make better decisions.