FA-6.2 - Compounding & the Main Asset Classes

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FINANCIALLY AESTHETIC · GUIDE 29/37
COMPOUNDING & THE MAIN ASSET CLASSES
FA-6.2 · Investing & Wealth Building
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BEFORE YOU INVEST

Compounding rewards time, but the path depends on what you own and which risks produce the return.

The Power of Compound Interest

“Compound interest is the greatest force in the entire universe.” This apocryphal maxim, attributed to Albert Einstein, highlights the power of accumulated interest. For a saver who lets their invested money grow without touching the income, doubling their capital is a matter of return on investment and… time.

Albert Einstein comes to our aid with his “Rule of 72,” which provides a quick method for calculating how long it takes for capital to double - a rule that another Albert, Dr. Albert Bartlett, a physics professor at the University of Colorado, rounded to 70 to simplify the calculation even further.

Let’s take, just as an example, the growth of a single euro invested: 1 € invested at 2% - divide 70 by 2. Your capital doubles in 35 years. 1 € invested at 5% - divide 70 by 5. Your capital doubles in 14 years.

ANNUAL RETURNROUNDED DURATION (RULE OF 70)


1%70 years

2%35 years

3%23.3 years

5%14 years

7%10 years

10%7 years

You can also see that a small difference in the annual investment rate leads to large differences in long-term results, especially when rates are high.

The compound interest graph shows what so-called “exponential” growth looks like over 30 years at different rates of return. A steady return of 5% per year means that for every €1 invested, you’ll have €2 after 14 years, €2.65 after 20 years, and €4.33 after 30 years. A steady return of 10% per year means that for every €1 invested, you’ll have €2.59 after 10 years, €6.72 after 20 years, and €17.45 after 30 years! Exponential growth is simply another way of describing the power of compound interest - that is, interest reinvested with the initial principal.

An investment yields a return of 10% per year. Invest 100 euros, and after one year you’ll have 110 euros. Your initial investment has therefore increased by 10 euros. In the second year, it grows another 10%, which now amounts to 11 euros. So the profit has gone from 10 euros to 11 euros. These calculations do not take into account inflation or the cost of taxes, which often varies depending on the taxpayer and the savings plans offered.

Returns and Risk: Two Inseparable Factors

Return and risk in financial investments are inseparable. They vary depending on the investment chosen. You cannot know in advance and with certainty what the return on an investment will be. Before investing, you must understand the risks associated with the financial product being offered.

Return and risk go hand in hand. A risk-free investment will yield little return. If you want to achieve a better return, you must be willing to take risks.

With stock market investments, there’s no guarantee of the return you’ll earn, but investing in equity investments over the long term helps reduce risk.

Before choosing an investment option, it’s important to consider the liquidity of the product being offered. Understanding an investment’s liquidity is essential to knowing whether you can access your savings quickly or not.

To assess the risk of an investment, you must consider its volatility in particular: this measures the extent of fluctuations in the value of a fund or a stock.

Euro-denominated funds: the “risk-free” investment

Euro funds in life insurance contracts offer savers a guarantee of the principal invested and the assurance that past gains are locked in (ratchet effect).

This investment has generated significant returns, particularly during the first ten years. The invested capital doubled in fourteen years (from 1995 to the end of 2009). Einstein’s rule makes it easy to see at a glance that, over this period, the average annual return was nearly 5% (70 divided by 14 years).

In contrast, as of the end of 2020, one would have had to invest in 1998 (22 years ago) to double the principal, resulting in a return of approximately 3.18% per year (70 divided by 22). This makes sense, as returns on euro-denominated funds in recent years have been lower.

Stocks: Supporting a Company’s Growth

Investing in stocks means supporting a company’s growth while hoping for good returns on your savings. Choosing stocks means opting for a long-term investment.

By investing in publicly traded stocks, you are financing the growth of publicly listed companies, while hoping to achieve a higher return over the long term than that of risk-free investments.

By definition, publicly traded stocks are volatile. Stock prices can therefore rise or fall each year.

Let’s continue this exercise with the CAC 40 index, which tracks the performance of shares in major listed companies in France. The rule of 70 also applies here. From the end of 1995 to the end of 2004 - a period of nine years - the capital doubled (1.00 → 2.04), representing a return of 70 divided by 9 = 7.78% per year.

In contrast, to double one’s capital by the end of 2018, one would have had to invest in early 1996 - a period of 22 years - due to the declines in the CAC 40 following the bursting of the dot-com bubble in 2001 - 2002 and the subprime crisis in 2008. The return calculated using Einstein’s rule indicates an annual rate of 3.18% (70 divided by 22).

But with the CAC 40 GR (Gross Return) index, which includes reinvested dividends, the picture is different. Over the course of the investment period, the capital has increased more than fivefold in 30 years! This makes sense, because in addition to the annual capital gain or loss, the result includes income and thus reflects the overall performance of the stocks.

But you don’t necessarily double your capital! If an investor had entered the market at the end of 2000 in the CAC 40 (with dividends not reinvested), an investor in French stocks who invested 1 euro would have only 94 centimes left after 20 years - a 6% loss of capital - as of December 31, 2020. The point at which you enter the market therefore has a significant impact on the final outcome.

Bonds: Loans to Borrowers

Bonds are issued by companies, the government, or local authorities that wish to borrow money on the financial markets and, in return, generally pay a regular income to investors.

Bonds are a medium- to long-term investment. You can invest directly or through funds and SICAVs, for example, in a securities account or an employee savings plan. However, this type of investment is not risk-free.

The price of fixed-rate bonds fluctuates in response to interest rate levels: if rates rise, the price falls, and vice versa.

Funds and SICAVs: A Collective and Diversified Investment

Would you like to improve the return on your savings? You can opt for a collective investment vehicle (OPC), such as a fund or a SICAV, which invests in securities like stocks and bonds.

UCIs (collective investment undertakings) invest in securities (stocks, bonds, etc.) on behalf of a large number of investors. By purchasing a share in a UCI, each investor gains access to a diversified portfolio managed by a professional (an authorized management company).

There are many different categories of funds, which can meet a variety of savings needs and are accessible with relatively small investment amounts. You can easily gain access to an already diversified portfolio without having to build it yourself. Funds can be a suitable solution for investors who lack the time or knowledge to invest directly in the stock market.

There is a very large number of funds, of different types, with varying risk levels and returns. They cater to a variety of investment strategies and time horizons: for example, by investing in certain asset classes (stocks, bonds, real estate, etc.), in specific geographic regions (Europe, the United States, Asia, etc.), or in particular economic sectors (pharmaceuticals, luxury goods, construction, etc.).

Investing in funds gives you access to markets that are difficult to access directly, such as the bond market. You also have the option to invest in foreign stock markets, which are similarly difficult to access directly and require specialized expertise for direct investment.

Keep in mind that while funds offer the potential for varying levels of returns, an investment in a fund can be risky: most funds carry a risk of capital loss, and performance is never guaranteed. However, by diversifying across several types of funds and investing for the long term, it is possible to reduce this risk. Invest only the savings you can afford to do without for several years (at least 10 years for equity funds).



Choosing Wisely Based on Your Profile, Time Horizon, and Desired Liquidity

Choosing the right investment fund (OPC) means, above all, understanding its potential returns and risk. Choose the type of fund that interests you based on its return potential or its benefits in terms of diversification. Compare funds to select the one that aligns with your investment strategy. Verify that the investment strategy is clear. Learn about the risk levels. Ensure that the recommended investment term matches your investment horizon.

Best practices for investing in funds and SICAVs: Choose your investments based on your goals, your risk tolerance, and your investment horizons. Before investing, read the Key Investment Information Document (KID) carefully and make sure you fully understand the investment strategy described. Review the fees and redemption terms. Monitor the performance of your investment regularly.

Thus, across the main asset classes - cash and euro-denominated funds, bonds, stocks, diversified funds, and real estate investment trusts - the return/risk/liquidity triangle is present at every stage: the higher the promised return, the greater the risk of capital loss and the uncertainty regarding the availability of your savings generally become.


INVESTOR CHECK

Understand cash, bonds, equities and real assets before mixing them; a higher expected return comes with uncertainty.

RISK NOTE

This guide is financial education, not a promise of returns or personalized investment advice. Products, tax treatment and investor protections vary by jurisdiction.

 
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