The Compounding Cost of Avoiding Volatility

With interest rates rising for cash, CDs, and bonds, there is renewed interest in owning more conservative investments instead of riskier assets like stocks. Since the best estimate of future bond returns is roughly their starting yield, 5% is probably a fair place to start (while nothing is certainly guaranteed). Stocks on the other hand have earned 10% per year on average.

For some investors, it may make sense to take less risk and “clip” the bond coupon, especially for the money they plan to spend in the coming years. But many investors, including retirees, often have a portion of their investments that are for long-term growth over 10-20+ years that have historically been in stocks. You might be tempted to shift some of this long-term growth money into conservative investments and earn roughly half the return (5% vs. 10%) with a lot less volatility. But the cost of this decision compounds over time. It may be half the return in the first year, but since the interest earned then also compounds, it becomes very lopsided given enough time.

Below is a chart of $100,000 invested at 5% vs. 10% over various time lengths.

By 10 years, you have 60% more, by 20 years you have over 2.5x the amount, and by 30 years you have 4x the amount.

Despite this, it’s vital to plan for short-term spending needs. And who knows if stock investors will get 10% per year. I think stock returns will likely be below their long-term averages over the coming decade. But if history is any guide, they will generally provide a premium to bond returns over the long run. Compounding for many years, that premium will likely provide a substantial benefit. As Buffett once said, “We prefer a lumpy 15% return to a smooth 12% return.” He knows a thing or two about compounding…

Happy Planning,

Alex

This blog post is not advice. Please read disclaimers.