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CAGR?

Compounding positively is a miracle but negative compounding is misery. Many investors followed conventional asset allocation "wisdom" and ran into the devastating NEGATIVE compounding of 2000-2002. There is no reason to assume future returns will be as high as the past. Historical precedent? The Dow did zero growth from late 1890s to the 1930s. Could the late 1990s be a similar predictor? How will your portfolio look if the Dow is LOWER in 2040 than today? Japan has had negative index "growth" for decades and other countries WILL follow Japan.

Could you wait decades for the so-called equity risk premium or alleged upward drift of the stock market to reassert itself or would you rather make money in the meantime? Last century the market only grew at a miserable 8% but with several major losses and extended drawdowns. It often took much, much longer than the "average" 9 years that the rule of 72 would imply before you doubled your money. Negative periods wreck that rule of thumb so beloved by people trying to sell you something.

Avoiding negative compounding is the key to successful investing. Hedge funds, due to the much criticised incentive fee MUST generate positive returns almost EVERY year to survive. They have to manage risk and recoup drawdowns as quickly as possible. The best way for investors to achieve target returns AND avoid negative compounding is a substantial allocation to well managed hedge funds. And that is why passive index tracker funds are much too risky for conservative investors like me.

Suppose you invest $100 in an index fund and the first year it is up 20% and the next year it loses 20% and this up/down cycle repeats for 20 years. (Such a scenario is not as unlikely as it sounds - check out the stock market since 1995). How much will you have at the end?

The surprising answer is you would have a grand total of JUST $66 and inflation kills whatever purchasing power $66 will have 20 years from now - a stick of gum, a can of soda but definitely not a gallon of gas. Avoiding major drawdowns is critical to future long term wealth.

As a convex function, positive compounding only really gets interesting at higher return levels. Over 20 years, which is more realistic than 60 years for most investors, at 4% compounded $100 grows to just $219. At 8% to $466. However at 15% to $1,636 and at 30% to the princely sum of $19,004, which is why hedge fund managers such as Warren Buffett, James Simons and George Soros are billionaires.

As usual the story is more complex than simply letting compounding do "miraculous" work. Negative years following a previous negative year screws up long term planning big time. If you lose 50% you need 100% performance to just get back to break even. Positive compounding is a convex function; it gets much more effective at higher numbers but of course SADLY also for negative compounding. Risk management to eliminate major drawdowns is mandatory. Don't invest in passive funds.

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