It is amazing how careful you need to be with numbers in this business. A few on-the-ball readers have pointed out to me that Richard Russell's compounding table, which was mentioned here a couple of weeks ago to illustrate the value of investing early, assumes a rate of growth of 10 per cent a year.
If you plug in a lower rate of growth, the striking conclusion - that the investor who invests £2,000 a year for seven years in his early 20s will end up with more money than one who has invested the same amount for 40 years, yet starting seven years later - no longer holds.
This is true. If you assume a growth rate of 6 per cent a year, for example, then the second investor will end up with a fund that is 46 per cent larger, net of contributions, at the age of 65.
In what is widely assumed to be a low-return era, that may be a more realistic assumption of the long-term returns available from the financial markets (although by one of those usual market ironies, ever since people started talking about single-digit returns becoming the norm, we have had three straight years when most investors with stock market exposure should have recorded a return that has been well into double figures).
In practice, of course, nobody's investments ever grow at a constant rate each year, as most projections of future returns implicitly assume. Ex post facto, for any long-term investor there will always have been opportunities when he or she could have locked in above-average returns given the gift of perfect timing. Many pension fund trustees, as we know, would have been wise to have done just that in the second half of the Nineties, when the bull market was entering its final years.
Instead, most were so preoccupied with comparing how well they had done with their peer group that they took their eye off the bigger picture. It is impossible to exaggerate how difficult most people find it to do something that differs from what everyone else does.
Yet the lesson to be learnt from any study of the greatest investors is always that they have the courage and the foresight to act differently from the crowd. They anticipate rather than react to the next big market swings, however much it may cost them in temporary underperformance.
By the same token, there will always be periods when even the most prudent investment plan is lagging its target investment rate. This is the point at which many investors throw in the towel, which is an even more expensive mistake than failing to lock in above-average gains. As Jack Bogle, the founder of Vanguard whom I mentioned last week, likes to point out, investing is ultimately an act of faith and you have to stay the course to gain the full benefits.
There are, however, two awkward assumptions hidden in that remark. One is that, for it to be valid, you have to be confident that you are investing in a sensible manner in the first place. Sticking to a badly conceived and executed plan is not going to do anyone any favours; indeed, in the worst case, it can leave you with compounding working against you rather than for you.
That this is a problem today is apparent. All too many investors, it appears, are disillusioned with their experiences and the service they feel they have received from the companies to whom they entrusted their money. Persistency rates in life company policies remain low, for example, meaning that many investors simply stop making contributions within the first five years.
The second awkward assumption is that there have clearly been times in history when capitalism does not provide the financial rewards that investors implicitly rely on to generate returns. As the authors of the comprehensive London Business School study of 20th century-returns, The Triumph of the Optimists, point out, the oft-heard argument that equities always produce a positive real return if you own them for 20 years is not as comforting as it sounds.
In fact, this only holds true for one stock market, which is that in the United States, which just happened to be the dominant economic force of the 20th century. It has almost always been true for the UK in the past 106 years, but for many other countries, such as France, Germany and Japan, the long-run historical record is nothing like as comforting.
While it is plausible to think that we will never endure a repeat of the horrors of the early part of the last century (two world wars, hyperinflation in Germany, the Communist takeover in 1917), it would be naive to take the continuation of today's long years of peaceful economic development for granted.
Will inflation ever be permanently beaten? It seems unlikely. Nothing is forever or for certain, in other words, and what appears wise from a mountain top in California may not be so true from a vantage point elsewhere in the world. The best one can say at any one point is that there is no current reason to take extreme precautionary measures, as our ancestors have had to do from time to time. Capitalism still looks in pretty good shape at the moment.
Whatever the shortcomings of Russell's table, however, the validity of the point he makes cannot be denied, as all those readers who wrote in also recognised. There may be better ways to illustrate the wonders of compounding, and other ways to underline the value of saving from an early age.
The most important thing, as any parent knows, is to find a way to make the case sufficiently persuasive to result in action. Judging by our national propensity to take on debt, this is a lesson that is still a long way from being learnt.Reuse content