How does compound interest actually work on investments?

IAMIAM

eskbanker said:

IAMIAM said:

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

A reality check?

Well the fund I have invested in has had a return of 12%, 11.25%, 16.5%, 10.1% and 9.8% for the last 5 years and has had 2 red years since first inception 16 years ago...
So tell me again in 5 years time or just come out with the usual one liner. Do not invest in funds based on previous performance Bla bla bla. 

In fact, I can just imagine you on an interview panel. Sorry mate, you are not getting the job based on your 14 year performance out of the last 16 years. We hire based on future performance so we've given the fund manager job to a school leaver on an apprenticeship. They should do much better than you. Good luck in your search.

eskbanker

IAMIAM said:

eskbanker said:

IAMIAM said:

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

A reality check?

Well the fund I have invested in has had a return of 12%, 11.25%, 16.5%, 10.1% and 9.8% for the last 5 years and has had 2 red years since first inception 16 years ago...
So tell me again in 5 years time or just come out with the usual one liner. Do not invest in funds based on previous performance Bla bla bla. 

In fact, I can just imagine you on an interview panel. Sorry mate, you are not getting the job based on your 14 year performance out of the last 16 years. We hire based on future performance so we've given the fund manager job to a school leaver on an apprenticeship. They should do much better than you. Good luck in your search.

Trouble with that analogy is that you're largely in control of your own performance, whereas obviously equity returns are highly variable and based on a huge range of macro and micro factors, ranging from the geopolitical to the success of individual new products, etc.

There's no harm in expecting long term returns to be in perhaps 6-8% territory on average, but the period since the last proper crash has been abnormally lengthy and productive, so it would be foolish to anticipate that continuing ad infinitum and to extrapolate performance from a five-year window during an extended bull run, especially when the absence of negative returns in those recent years increases the prospect of them occurring again in the next period.

So, although my remark was mainly flippant, the underlying sentiment remains valid, i.e. that's it's at least ambitious, if not downright reckless, to plan on 10% returns over a genuinely long term period - in other words, the point wasn't really "Do not invest in funds based on previous performance" as such but to interpret that past performance with some context rather than seeing it too simplistically....

[Deleted User]

IAMIAM said:

Great, I am set on depositing £5k into a LISA per year at the start of each tax year for the next 15 years and potentially £5k into a S&S ISA too (ultimately saving £9k per year)

Hi,

seems you can only save £4000 a year in LISA with bonus of £1000,

Have a look HERE.

MaxiRobriguez

IAMIAM said:

eskbanker said:

IAMIAM said:

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

A reality check?

Well the fund I have invested in has had a return of 12%, 11.25%, 16.5%, 10.1% and 9.8% for the last 5 years and has had 2 red years since first inception 16 years ago...
So tell me again in 5 years time or just come out with the usual one liner. Do not invest in funds based on previous performance Bla bla bla. 

In fact, I can just imagine you on an interview panel. Sorry mate, you are not getting the job based on your 14 year performance out of the last 16 years. We hire based on future performance so we've given the fund manager job to a school leaver on an apprenticeship. They should do much better than you. Good luck in your search.

Reversion to the mean is real. 

There's a bigger chance your fund underperforms for the next 5 years than continues posting double digit growth.

Be cautious with extrapolating good gains over a number of years as it will paint an unrealistic picture. I find it better to extrapolate poor returns - at least then it gives me a baseline to work to, ie: if I'm only getting X returns I need to contribute Y to make my final target. 

If market returns are better then great, I'll just buy a bigger boat. Better approach than planning to buy a big boat, not contributing as much as you could because you forecasted X% returns and the actual returns are lower to the extend you can only afford a canoe. 

Thrugelmir

IAMIAM said:

eskbanker said:

IAMIAM said:

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

A reality check?

Well the fund I have invested in has had a return of 12%, 11.25%, 16.5%, 10.1% and 9.8% for the last 5 years and has had 2 red years since first inception 16 years ago...
So tell me again in 5 years time or just come out with the usual one liner. Do not invest in funds based on previous performance Bla bla bla. 

Overconfidence bias is nothing new. “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria". Wise words that have stood the test of time whatever the market traded. 

Amazin

Quick question:

if an asset has a return of 100% over 5 years then I'm assuming it's 20% return per year on average and it doesn't matter if the percentage is different each year because you will end up with the same amount of money after 5 years? 

grumiofoundation

Amazin said:

Quick question:

if an asset has a return of 100% over 5 years then I'm assuming it's 20% return per year on average and it doesn't matter if the percentage is different each year because you will end up with the same amount of money after 5 years? 

Yes and no.

Yes if after 5 years you have a 100% return then it doesn’t really matter what return got each year. 

It’s not really 20% per year - you only need 14% interest over 5 year to get a 100% return due to the impact of compound interest. (Assuming you were compounding the interest).

But also the case as made earlier that won’t get same return each year.

kuratowski

To develop this point, if you pay in a lump sum at the beginning and make no further contributions and no withdrawals, then the exact sequence of returns is irrelevant.

However, if you are making regular contributions (accumulation), let's say a fixed amount per month, then the variability of returns is actually a benefit, as it means that you'll be buying extra units when the market is low, and buying fewer units when the market is high, i.e. your average cost of units is lower.

Conversely, if you are making regular withdrawals (decumulation), then the variability of returns is a curse, because if you get a sequence of bad returns near the beginning, then you will run out of money more quickly.  "Sequence of returns risk."

Amazin

grumiofoundation said:

Amazin said:

Quick question:

if an asset has a return of 100% over 5 years then I'm assuming it's 20% return per year on average and it doesn't matter if the percentage is different each year because you will end up with the same amount of money after 5 years? 

Yes and no.

Yes if after 5 years you have a 100% return then it doesn’t really matter what return got each year. 

It’s not really 20% per year - you only need 14% interest over 5 year to get a 100% return due to the impact of compound interest. (Assuming you were compounding the interest).

But also the case as made earlier that won’t get same return each year.

aahh, I thought compound interest over time will give you more than 100% (from initial amount) over time. Thank you! 

kuratowski said:

To develop this point, if you pay in a lump sum at the beginning and make no further contributions and no withdrawals, then the exact sequence of returns is irrelevant.

However, if you are making regular contributions (accumulation), let's say a fixed amount per month, then the variability of returns is actually a benefit, as it means that you'll be buying extra units when the market is low, and buying fewer units when the market is high, i.e. your average cost of units is lower.

Conversely, if you are making regular withdrawals (decumulation), then the variability of returns is a curse, because if you get a sequence of bad returns near the beginning, then you will run out of money more quickly.  "Sequence of returns risk."

thanks for that info, never thought about it before. You guys are super helpful