The Eighth Wonder Of The World!

According to Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Unfortunately an awful lot of people don’t properly understand how this can affect long term investments such as pensions.

Suppose you invest £10,000 today in a fund which produces a 7% annual return for the next twenty years and charges 0.3% per year for managing your money. You will finish up with a fund value of £36,584. But if that same fund was charging 2.0% per year, you’d end up with just £26,533 – a whopping 27% less!

Yet time after time I see clients and potential clients who’ve invested in funds charging 2.0% and often more. This would be fine if the investments were actively managed following an approach likely to beat the market, but all too often in my view they are with pretty ordinary fund managers more likely to be beaten by the market.

So to add insult to injury, the high charges are often followed up with duff performance. My advice to such people is simple – an index tracking fund charging less than 0.5% per year should be your first port of call unless you are convinced you’ve found someone with an approach which will beat the market most years.

I like investing directly in my own share choices, and over the last 15 years on average have beaten the market by 3% per year. One of my golden rules is to sell a share as soon as it has fallen 25%, even if that happens only a few days after I’ve bought it. Ruthlessly cutting losses on duff investments is my second piece of advice everyone can follow. Another related rule is that when an investment gains 25% – and only then – I consider buying more of it.

No-one invests with the hope of losing 25% of their money in short order. But all too often people carry on holding such duffers unquestioningly, and risk having the 25% hit turning into 50% or even more. Something which has fallen 25% needs to rise 33% to get back where it started. If it has fallen 50% it then needs to double which is a mountain to climb.

If you’ve been in this position in recent years, make your resolution for 2013 that this is going to be the year that compound interest works for you, not against you. Cut your losses on any poorly performing, high charging funds and start moving to index trackers which suit your attitude to risk. Continue doing this over time, cut losers and put more money into winners, and you’ll reap the rewards of the eighth wonder of the World!

Postscript – two independent financial advisors (IFA) have separately threatened to report me to my Institute over previous articles like this one. In my opinion, there is overwhelming evidence for every word of it. So if you are an aggrieved IFA, put up or shut up!

Tuesday 20 August 2013