Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”. Compounding is often seen as a fundamental financial strategy, harnessing the exponential growth of an investment over time as the interest earned generates its own interest. This “snowball” effect can lead to significant growth, especially over long periods, making it an ideal strategy for high-net-worth families and individuals with long time horizons.
Sounds simple, right? Just find an investment, put your money in, and let compounding work its magic. However, there’s an important caution: you must be very selective about what you invest in. You can’t just throw your money at any investment or smooth-talking fund manager with a slick PowerPoint presentation. Here’s why: the compounding effect of a poor investment or a flawed strategy where you earn 0 is 0. Even worse, you lose your initial investment, and more importantly, the opportunity cost of that capital is significant—it could have been deployed elsewhere.
Investing in illiquid assets like private equity, venture capital, and private debt complicates the compounding game even further. In private markets, there is a significant dispersion between winners and losers. Winners tend to win big, while losers often suffer severe losses. I always tell my clients that there is no such thing as an ‘average private equity manager.’ The spread in returns is substantial. The chart below illustrates the disparity in returns between public markets (such as fixed income and equities) and private markets (like distressed debt, real estate, buyouts, and venture capital). The spread between the top and bottom quartile performing funds, represented by the distance between the two lines, highlights what I call the ‘Zero or Hero’ phenomenon. A manager’s returns are usually either great or terrible; there is no real in-between.”
What’s more, the illiquid nature of these investments means that by the time you realise you’re stuck in a dud, you can’t get out and usually several years have passed. Urgh!
The lesson in all of this is that who you invest with and what you invest in really matters, especially when investing in illiquid assets. If you’re aiming to capture the liquidity premium (find out about this here) and play the compounding game, you need to make the right investment choices, because the compound of 0 is still 0.
Kind regards,
Shelley Marsh
Outsourced Chief Investment Officer (OCIO) & Founder
Wealth Differently
General Advice Warning: This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. It does not represent and is not intended to be personal advice. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs. We strongly suggest that you seek professional financial advice before acting.
Wealth Differently Pty Ltd AFSL 547820.
