Were I able to go back in time to impart one piece of wisdom to my teenage self – one nugget that would have made all the difference to my financial future – I would somehow engineer the absence of my maths teacher for a single lesson.

Then, heavily disguised as fresh supply teacher meat, I would instruct the class in the power of compound interest.

It wouldn’t take long, needn’t tear a hole in the fabric of space-time, and it would have made a far deeper impression on me than another drone-a-thon about quadratic equations.

Because everyone likes the idea of money for nothing.

Alas in reality what little money I did lay my hands on at that time went on instant gratification. You know how it goes.

If only I had understood what a mighty money tree I could grow by saving even a pitiful amount early on and watering it with time and compound interest!

How compound interest works

Compound interest is the astonishing multiplier effect1 of interest earned on interest, over time.

It works like this for a saver who sticks away £1 and earns interest of 10%:

Year	Principal	Interest @ 10%	Total
1	£1	10p	£1.10
2	£1.10	11p	£1.21

In Year Two, you don’t add a bean to your savings, yet you still rack up more interest than the previous year (11p instead of 10p), because you also earned 10% interest on your interest.

Big wow. It doesn’t sound so life-changing – until you scale up the amounts and timescale involved.

Once that self-feeding, compound interest mechanism gathers momentum it creates a runaway money snowball that can transform your financial position.

But time is needed to generate that momentum. The sooner you start saving and investing, the more dramatically compound interest can work for you.

Compound interest unleashed

Let’s consider two investors: Captain Sensible and Captain Blithe.

From the age of 25, Captain Sensible invests £2,000 per year in an ISA for 10 years until he is 35. At 35 he stops and never puts another penny into his fund again.

Captain Sensible then leaves his nest egg untouched to grow until he hits age 65. He earns an average annual return of 8%2 and when he looks at his account 30 years later, he has £314,870 to play with.

Captain Blithe, meanwhile, spends the lot between the ages of 25 to 35. Only when he hits 35 does he sober up and start tucking away £2,000 per year in his ISA. He keeps this up for the next 30 years until he reaches 65.

Captain Blithe earns an average annual return of 8%, too. He ends up with £244,691.

To recap:

• Captain Sensible has invested a total of £20,000.
• Captain Blithe has invested a total of £60,000.

Yet Captain Sensible’s pile is worth over 28% more than the late-starting Captain Blithe’s – even though Sensible only invested a third of the amount.

Do it. Do it now!

Remember our ho-hum interest table above? Let’s dial up the years setting to 30 to see how she performs:

Year	Principal	Interest @ 10%	Total
1	£1	10p	£1.10
30	£17.45	174p	£19.19

After 30 years at 10%, you’re earning almost twice your entire initial investment as annual interest. That’s the power of compound interest.

Of course, the only place you can hope to get a 10% return these days is the stock market, and stocks go down as well as up. Real-life returns are more volatile, but the principle is rock solid.

Compound interest is an offer you’d be mad to refuse. Have a play with our compound interest calculator to see how much you can achieve.

When you’re young, time is on your side. Make the most of the once-in-a-lifetime opportunity by sticking some money away (anything is better than nothing) and let compound interest get to work securing your future.

You’ll be laughing later. (At me, as I snivel and regret my youthful folly).

Take it steady,

The Accumulator

P.S. – Even if you’re not so young, now is still the best time to start.

1. At this point most compound interest articles like to quote Albert Einstein as saying: “The most powerful force in the universe is compound interest.” It seems more likely that this is an internet meme than an Einstein quote, but it lives on because it would be fantastic if true. [↩]
2. That is, an 8% annual average return over the entire 40-year investment period. [↩]

Good reads from around the Web.

Until you pay attention – as more of us have with ongoing the oil price crash – it’s hard to fathom just how volatile commodities can be.

Even veteran investors who have a handle on the ups and downs of the stock market can turn seasick looking at a graph of the choppy pricing of copper, corn or gold.

The stock market can seem a millpond by comparison.

The following table from US Global Investors1 shows how a metal like nickel can soar 154% one year before slumping 24% and then a further 55% in the following two years, and then rally 59%!

The original graph is interactive. Hours minutes of fun!

Slippery slopes

Being aware of this volatility obviously matters a lot if you’re an active investor.

It’s easy to get sucked into buying, say, oil exploration companies because they’ve fallen 20% on a 10% dip in the oil price.

After the oil price has fallen 80% and your shares are down 90%, you can reflect on your haste at your leisure.

Personally, I think commodity prices in today’s globalised and ‘financial-ised’ world are probably unpredictable even by experts.

That doesn’t mean you can’t invest in companies that churn them out, but it does imply that as a stock picker I want to be buying firms I judge can do well over a wide range of prices.

Now, many amateur experts will (in the good times) say different.

Hoards of private investors became part-time experts on the oil and gas industry, for instance, over the past decade, and on small cap gold mining companies for much of it, too, and loaded up their portfolios to the seams with such shares when prices were high.

And many have lost at least half their shirts in the subsequent rout.

I’m not belittling their expertise or ambitions. (That would be pretty hypocritical of me, given I am equally barmy in engaging in active investing myself.)

But I would observe that correctly judging which is the superior small cap oil company can be a hollow victory if it means that when the whole sector falls by 90%, you only lose 80% of your investment.

In this case you’d clearly have been better off out altogether. But from observation it seemed that many experts were wildly over-exposed – and emotionally committed – to the sector, and they followed the market down.

I’m not saying there’s never a time to invest in such companies. (Disclosure: I hope now is such a time, as I’ve loaded up, on and off, over the past 3-6 months).

But in my opinion, the hugely volatile nature of commodities means an active investor in the sector needs to be a confident trader, too, who is prepared to chop and change based on (gasp!) price action.

Passively poorer

Passive investors should also be aware of commodity price volatility.

That’s because every so often – usually after a couple of good years for the asset class – some people will start advising you to add direct commodity exposure to your portfolio as a diversifier.

I don’t mean to buy the major oil companies or miners that you will have exposure too anyway via your index funds.

I mean specific commodity exposure, through Exchange Traded Products or some other sort of futures fund.

From his own research, my co-blogger The Accumulator has typically been wary of that advice, and the latest US data suggests he is right to be cautious.

The following table – tweeted out by Morningstar’s editor-in-chief Jerry Kerns – shows how commodities have generally done nothing good for portfolios over the past 15 years:

Buy the dip?

Now you might be thinking this all sounds a bit defeatist. Don’t we normally suggest that slumps in a market can be a good time to buy in?

Well, I think that’s possibly true of companies that produce commodities, as I’ve alluded to above.

But being exposed directly to commodities themselves is a different matter.

Many financial assets – houses, equities, land – greatly appreciate in real terms over the long-term, despite the ups and downs on the way.

But there’s much less of that long-term appreciation in commodities in real terms, because we get better at extracting them and at exploiting them.

Perhaps someday that will change (that’s what the commodity super-cycle theory was all about) but it’s not done so yet.

And at the same time the prices are very volatile, so you’re basically adding risk without reward.

There are also extra costs and technical reasons why getting exposure to commodities via financial assets can be disappointing, too.

Let the smart money figure it out

As always, there will be exceptions – a few rare and successful market timers, whether by luck or skill, and some hedge funds and the like that have managed to get good returns over multiple cycles from the commodities markets.

But generally, I believe most people will be better off just owning whatever the global stock market owns when it comes to commodity-extracting companies.

[continue reading…]

1. Via Abnormal Returns. [↩]

A friend of mine has a knack of homing in on financial folly like a dowsing rod waved above the Atlantic finds water.

This week he proudly informed me that he’d bought a short ETF.

He hasn’t done so because he’s got too much money and thought the financial services industry deserved a donation, via yet another poorly understood product.

No, he believed that holding a short ETF would help protect his portfolio if we are hit by further bear market declines.

It might sound good in theory – although I’d argue it’s better to think about portfolio protection before the market has already slumped 20% and the crash is mainstream news, and that the best way to reduce your risk is simply to sell – but anyway, the maths of how a short ETF works is rather different to what my friend imagined.

If my friend holds the short ETF the way he planned to, he could lose money even if the market does fall.

Insurance that costs you money when you expect it to pay out is surely even worse than having no insurance!

In this post I’ll explain why my friend was wrong to buy a short ETF to try to insulate his portfolio from a prolonged downturn in the stock market. (Next week we’ll consider what he might have done instead).

What is a short ETF?

A short ETF (also called an inverse ETF) is an Exchange Traded Fund that delivers the opposite of the daily return from its underlying benchmark – often an existing, conventional ETF.

For example, the db X-Tracker FTSE 100 Short Daily ETF from Deutsche Bank (factsheet) delivers the opposite of the return you’d get from the bank’s normal FTSE 100 ETF tracker.

• If the FTSE 100 falls 1% in a day, the short ETF will rise 1%

• If the FTSE 100 rises 1% in a day, the short ETF will fall 1%

You can also get leveraged short ETFs, which usually have 2x or 3x in the title. As the name implies, these ETFs return two or three times the opposite of the daily return of their benchmark.

Short ETFs are synthetic ETFs with the usual risks you’d expect from such securities, such as counterparty risk.

But there’s a more fundamental problem with short ETFs – at least in the way many uninformed buyers aim to use them.

The snag: The only way is not up

The problem arises due to the way that the mathematics of compounding works.

Maths will probably not be on your side with a short ETF should you hold it for more than a day or two.

Over one day, short ETFs do what they say they’ll do on the tin (not that every buyer reads the label). They deliver the opposite of the benchmark’s return.

The trouble comes if you hold a short ETF for more than one day, let alone the weeks or months my friend had planned in order to try to offset any losses from a falling stock market.

Because of the impact of compounding, longer-term returns will be more or less than you’d expect from simply summing the inverse of the daily returns.

The impact is especially noticeable in volatile market conditions. Which is to say most market conditions – shares rarely go up or down in a straight line for long.

Examples of how short ETFs work in practice

This is all pretty counter-intuitive, so let’s illustrate it with a couple of examples.

Let’s say we’re bearish about the FTSE 100, because it’s just broken through the 10,000 level and we think that’s quite enough for now.

We decide to buy £10,000 worth of a short ETF that delivers the inverse of the FTSE 100.

In other words, if the FTSE 100 falls 1% in a day, we’ll gain 1% on our £10,000, and vice versa.

In addition, my friend – let’s call him Harry – decides to go one better, buying a 2x short ETF with his £10,000.

If the market falls 1% in a day, for example, Harry expects to gain 2%.

Example 1: A declining market

We buy our ETFs on Monday. Let’s say we’re even luckier than we deserve given we’re punting on a single day’s return from the FTSE. The market falls 2%.

Here are the returns1:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9800	-2.00%	£10,200	£10,400

 

So the index fell 2% and we made £200 on our £10,000 investment. Harry has made £400.

All as expected so far.

Now we get greedy and think the market will keep falling. (Why are we so confident? Perhaps we heard it on CNBC. Those guys are never wrong…)

Let’s say the market falls 2% a day every day for the rest of the week.  That’s five days of 2% declines.

Think we’ll be up 10% at the end of the week? Think again!

Here’s how our returns stand by the end of play Friday:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9800	-2.00%	£10,200	£10,400
9604	-2.00%	£10,404	£10,816
9412	-2.00%	£10,612	£11,249
9224	-2.00%	£10,824	£11,699
9039	-2.00%	£11,041	£12,167
-9.61%		10.41%	21.67%

 

As you can see, the way the compounding works, the FTSE 100 index has declined by a little less than the 10% you might have expected.

Similarly, the short ETFs are both more than 10% ahead. Already we can see the returns aren’t the simple opposite of the underlying index, due to compounding.

Incidentally if the market had actually risen by 2% a day – thwarting our purchase of the short ETF – then this relative performance would have been reversed.

Example 2: A volatile, declining market

Sometimes markets go in one direction for a week or so, but in practice they’re usually more volatile. Two steps forward and one step back is more common, whatever the overall direction of travel.

Here’s how our two short ETFs perform in a bumpier market:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9500	-5.0%	£10,500	£11,000
9975	5.0%	£9,975	£9,900
9476	-5.0%	£10,474	£10,890
9950	5.0%	£9,950	£9,801
9453	-5.0%	£10,448	£10,781
-5.47%		4.48%	7.81%

 

In this example, the index has declined by 5.47%, but the short ETF has only climbed by 4.48%. Meanwhile the 2x short ETF has grown far less than the near-11% gain you might have expected from simply doubling the index’s decline.

All sorts of different outcomes are possible depending on exactly what numbers you plug in. Try creating a spreadsheet and having a play.

Example 3: A volatile yet flat market

Perhaps the most shocking example of how you can come unstuck with a short ETF is when the market is flat over the period, yet you still lose money.

Take a look at this sequence of returns:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9000	-10.0%	£11,000	£12,000
9450	5.0%	£10,450	£10,800
9923	5.0%	£9,928	£9,720
9625	-3.0%	£10,225	£10,303
10000	3.9%	£9,827	£9,500
0.00%		-1.73%	-5.00%

 

Here we see that after five very volatile days, the index has ended up exactly where it began.

In contrast, we’ve lost money on the short ETF and Harry has pretty much taken a bath on his 2x leveraged one!

This isn’t because these ETF products don’t work. They are doing what they are meant to do, which is deliver the opposite of the daily return, with knobs on in the case of the 2x short ETF.

It’s all down to the mathematics of compounding.

Short ETFs deviate in the real world, too

This is not a case of odd examples chosen to prove a point. Such behaviour from short ETFs happens very often in the real world, too.

A striking example cited by the FT a while ago involved a double leveraged short ETF based on the FTSE Xinhua China 25 index.

After the Beijing Olympics, this index fell 34% in four months. Yet rather than making a 68% gain, the short ETF delivered a 56% loss!

More mundanely, you may simply find that your long-term holding of a short ETF does go in the right direction, but for the reasons I’ve cited it turns out to not be enough to offset the declines you’re trying to guard against.

For instance, between 1 April 2015 and now the FTSE 100 has declined by nearly 12%, but the DB X-Trackers DBX FTSE 100 Daily Short ETF (Ticker: XUKS) has only risen by 7%.

So much for protecting your portfolio.

Again, I stress that’s not to say these products are doing anything wrong – rather they are doing what they are meant to do, which is offering inverse correlation to the index on a daily basis, in this case to the FTSE 100.

But if you buy and hold them as longer-term portfolio protectors, then you are doing something wrong, though exactly what result you’ll get – good or ill – will depend on the lottery of volatility over the period.

Note too that there may be other reasons for deviations with short ETFs, involving costs, taxes, dividends, and also financing charges in the case of leveraged ETFs.

The compounding effect is the most important one though, and reason enough for everyone but day traders to avoid these ETFs entirely!

(And you already know that you should avoid being a day trader…)

Further reading on short ETFs:

• ETF Securities has a comprehensive PDF about short and leveraged ETFs.

• The US Securities and Exchange Commission has issued a warning about short ETFs.

• Here’s some better ways to protect your portfolio.

1. For simplicity, I’m obviously ignoring the TER cost of the ETFs in all these examples. [↩]