You must be living under a rock if you have not been affected by SARS-CoV-2 and the severe disease that has cost millions of people their lives. The disease COVID-19, caused by the virus, has gripped the world and changed the lives of billions of people. The novel Coronavirus SARS-CoV-2 has infected 100s of millions of people and caused many millions of lives. Not to mention the economic disruptions in all countries of the world and the loss of many freedoms we take for granted.
The danger of the virus is that it is easily transmissible between humans, by simply being in the same room for long enough.
If you follow the news, you have heard that the virus infects people with exponential growth unless drastic countermeasures are taken. Exponential growth describes a growth rate that is not constant but grows from period to period by itself. If that happens with the disease then there are not enough hospital beds, personal, and supplies to treat the severely sick. This of course is a catastrophic outcome.
R-Value
To describe the growth rate scientists use a measure called the R-value, short for reproduction value. The R-Value describes how many people are newly infected by one sick person. If it is above 1.0, then the rate of infections is growing, if it is below 1.0 then the disease is abating.
The exponential growth comes from the compounding effects of an R-Value over 1.0. The Corona Virus is estimated to have a natural R-value of 3. So if no measures are taken, each sick individual would infect 3 others with COVID-19. After one round we have three, after two rounds the three people infect 3 each, so we now have 9 new infections. After three rounds we’ll have 27 new infections, then 81, then 243, and so on. The natural rate of growth would infect the entire population of the US within less than 18 rounds of compounding. Assume each round plays out in a week, that is about 3.5 months. This is the power of compounding.
Compounding interest
In investing the same powerful math is to our benefit. If you can save and invest money for the long term, e.g. for many rounds, then you will have the interest compound and the growth of your wealth increases exponentially. And all that without you adding additional money.
Let’s say you have an investment that has a return of 7% / year, then it doubles its value in 11 years. In 21 years that same saved amount has quadrupled and after 40 years it has grown to be 15 times the original savings.
Now think of that $1,000 you can put away at age 27. By the time you retire, 40 years later you’d be able to spend $15,000 in the first year of your retirement. Would you be interested, if I told you that major US stock market indices have an average compounded return on investment of ~ 7%?
Inflation
Now the knowledgeable reader will say, but what about inflation? And you’d be right. Our money system is built in a way that money does lose ever so slightly its value. If today you buy for a dollar 5 rolls, in 40 years from now you might only get 2.5 rolls for the same amount. This means you’d need 2 dollars to nourish your body with 5 rolls in 40 years. I’d still be happy with $15 from my $1 savings, even if it buys me only half the goods.
It’s the same math at work here, as in COVID and its R-value, what is different is the rate and the time period over which the rate compounds. While in a virus pandemic the time period is 1 week, in investing it is usually expressed in years. Furthermore, the compounding rate is usually a few percent, rather than 300% like the Saas-CoV-2 spread.
Averages gloss over the many different outcomes
R-values in the COVID-19 pandemic are estimated based on measured infection rates over some time and large areas. This is useful if you are the national government to get an overall picture, and plan countermeasures to protect the population from the disease and its devastating consequences. However, the rapid spread of the disease in one city is averaged with an actual reduction in some other areas.
The same is true for the stock markets. Some stocks may grow at a much higher rate than average, while others are lagging. So looking at indices averages a lot of different stocks together to come at a single number to measure stock market valuations.
But even looking at indices with large numbers of US stocks, their value does not grow in a nice steady fashion, as our much-simplified model above suggests. If you’ll buy this index fund or ETF, you’ll see its value rise and fall in rates that are not steady nor predictable. It’s only that after long periods of time you could reasonably expect that your dollar has grown at a compounded rate of 7%/yr.
Just as we have seen with the pandemic, where new infections have risen and fallen and risen again, so does the stock market has its up and downs.
Stay invested for the long term
The thought of compounding interest has motivated me to put some of my income into savings and let it work as an investment. You do not need to be an investment expert. You can do this yourself, and enjoy a safe retirement income.
Also keep in mind, that in investing, past returns are no guarantee for the future. While we can observe and measure the past behavior of markets, we can not for sure predict that this past behavior will continue. It is just the best estimate we have.