The magic of compound growth

It's time now! Young folks head back to school in a few weeks, back to the world of books and lessons. What better time for the most wondrous financial lesson of all: the magic of compounding.

Compound growth turns a small sum into a large one in your lifetime. Crucial for young and old alike! Most folks have much more time than they think. Life expectancies are longer and growing. Average life expectancy at birth jumped from 76.8 years for UK females in 1980 to 82.7 years today. UK males' life expectancy at birth soared from 70.8 years in 1980 to 78.9 years now. Those are just averages - many folks live longer, and actuarial tables habitually underestimate. Lifespans will keep rising, too, thanks to medical advances - testing, analysis and treatment - and healthier lifestyles. Think how active most retirees are today compared to decades ago!

Compounding is as key for a 60-year-old as a 16-year-old. Someone near 60 could have another 30 years or more to compound, easily. Since 1933, world stocks have never fallen over a 30-year stretch. Compound growth potential is astounding.

If you invest £100,000 in stocks today, and annualise 6% returns, in 30 years you have almost £575,000. In 60 years, you have about £3.3 million. Think of it! You can buy a 30-year gilt at 2.5%, earning taxable interest but not growth. Invest £100,000, and you'd get £75,000 in interest over 30 years. Or you can compound stocks at 6%, have nearly six times your investment in 30 years, and more than 30 times your investment after 60 years. To equal stocks compounding at 6%, a bond must yield 16%. Double current Greek yields, with Greek-like default risk.

It's a no-brainer

Then again, what if stocks average 10% annually over the next 60 years as they did over the last 60? In 30 years you'd have over £1.7 million. In 60 years you'd have almost £30.5 million. Stocks would give you millions. Gilts give you thousands. Gilt-linked annuities yield similarly while locking up your savings. It's a no-brainer.

If you're around 60 and investing for retirement, unless you have Bill Gates' billions, you need compound growth. The difference between £575,000 and £175,000 (gilt principal plus interest) is a life-changing opportunity cost. £400,000 in missed returns if stocks average 6%. Over £1.5 million in missed returns if stocks average 10%. Money you don't earn - opportunity cost - is money lost.

Don't be imprudent, of course. If you need cash flow, set aside enough (in cash or gilts) to get through a stockmarket downturn, so you don't have to sell when stocks are depressed. But beyond that, you need the higher return. It's the difference between your savings lasting your lifetime or running out before you die. It's the difference between having freedom to travel, play and spoil your grandkids or having to pinch pennies. Everyone says gilts are stable, and in terms of volatility, that is true enough. But real personal stability comes from big compound growth. You can't get that from fixed interest.

Perhaps you think "but I won't live that long, so I need gilts!" Maybe, if you have bad genetics or don't take care of yourself, your time horizon is shorter. Circumstances vary. But unless you have a spotty family health history or smoke three packs a day, you likely have longer than you think.

Own stocks today!

However long you have, if growth is what you need, the sooner you invest your savings, the longer compound growth's magic will work for you. So don't delay - own stocks today! Here are two:

Target is America's third-largest discount retailer. It is also losing money and up against Wal-Mart, and discount margins are thin in the best of the times. So why recommend it? Am I just nuts? Well, I'm crazy for solid turnarounds. Yes, Amazon is changing everything, but as behaviourists teach us, people are slow to learn, and Target didn't get to be number three in a tough turf for no reason. It has great locations and great merchandising. It has been trimming and toughening. And I think it will earn $5 billion in two years. By then the stock should be up 50%. You get a 2.5% dividend yield while waiting.

Another real moneyloser I like lots is Ireland-based drug giant Allergan. It's incorrectly viewed by institutions - too much owned by passive funds and not enough by traditional active ones (which, as they gain confidence in it, should bid up the price). And where it is owned by active institutions it is mostly as an alternative to generic drug firms. My bet is before this bull market ends it's treated more like mainstream proprietary druggies and is nicely higher.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.