The iron law of compound interest

Robin Powell of the Evidence Based Investor & Financial Journalist Norma Cohen reflect on the iron law of compound interest

RP: There are very few certainties with investing. But there is, thankfully, one controlling principle that is incontrovertible.

Journalist Norma Cohen calls it the iron law of compound interest.

Originally from New York, Norma has worked as a correspondent for the Financial Times for many years.

NC: The iron law of compound of interest formed the basis for the formation of the insurance industry in Britain in the 17th Century, once economists and mathematicians figured out what it was. And that is that, if you have an investment and the investment earns a rate of return in a single year, the following year, the money you have available for investment is equal to the initial contribution plus whatever was earned in interest during that year. And each year that that money remains invested, the size - the contribution made by the interest - becomes larger and larger.

RP: Unfortunately, compound interest also works the other way round. So, for example, if you don’t pay off your credit card in full each month, you might end up paying interest on interest on interest.

And it’s the same principle with investment fees and charges.

NC: The Dutch financial regulators have done some calculations that offer a kind of a rule of thumb. And for a quarter of a percentage point, which is only 25 basis points (0.25%) which is well below what many investments in Britain are charging every year. If you have to pay that out over a 40-year lifetime of saving for your pension, it will reduce the lump sum you receive at retirement by 7.5%.

RP: As Norma Cohen says, most investors around the world pay far more than a quarter of one per cent for investment management.

It’s also important to note that the annual fund management charge is only part of what you actually pay.

NC: For example, there has to be a custodian for your share certificates. There is a cost of transferring your payment to a broker. That’s a charge. There is a cost of providing you with information about your investments. And then there is something called the frictional cost of trading, which is the difference between what - let’s say - a share is offered for sale at, and what somebody is willing to buy at. There’s usually a spread.

If you have a fund manager who trades a lot – where 120% of your portfolio turns over every year into new securities that the manager decides have a better chance of earning high rates of return – you will be paying far, far more in fees and charges than you would if you had a fund manager for whom only a fifth of the portfolio turns over every year.

RP: The problem is that the investing industry tends to keep all these different costs opaque and hard to calculate. That’s despite efforts from financial regulators to increase transparency.

NC: It’s like airline charges. Why don’t you hear more about the extra costs of bringing a carry-on luggage? Those who impose the charges have absolutely zero interest in explaining to you exactly what the charges are. That’s how they make their money! What’s starting to happen, mercifully, is that investors are becoming more aware of charges, fees, and costs; and now savvy investors are going out and looking for the kinds of arrangements that will help them to keep their fees down.

RP: So, be savvy. When choosing a financial adviser, remember to ask them about investment costs. If they only use expensive, actively managed funds, you should steer clear.