The imposition and miracle of compound interest

Unlike his life, Ronald Reed’s death made headlines in 2015. How could this janitor and gas station worker amass a fortune of $8 million?

Pierre Gallis, Senior Overlay & Volatility Manager

The answer is as simple as his extraordinary investments: he lived modestly and methodically invested the rest of his salary for 50 years in stocks in America’s biggest companies, never selling or reinvesting dividends, and then letting compound interest do its thing.

Einstein called compound interest the eighth wonder of the world. We understand why.

For example, similar investments $100,000 realized in 1988 on the S&P through dividend reinvestment would have been multiplied by almost 39 times for $3,878,782.

However, over such a long period, it is interesting to study the factors that affect the final result. First, we often hear that the stock market brings in an average of 7-8% per year. For the period under review, the S&P average was even higher at 12.80%.

On the other hand, calculating the final value of an investment with a return on investment of 12.80% per year for 34 years, we get: $6,004,950 that is more than 1.5 times the terminal value noted earlier.

Why such difference?

In a word: due to volatility. Although two investments may have the same average, the final value is highly affected by volatility. Caricature this moment and consider three years: let’s take one year with -75% and the next two years with +100%. Average 41.7% while the investment would give him 1*(1-75%)*(1+100%)*(1+100%) = 1, i.e. 0% performance for 3 years.

Indeed, let’s remember what returns are needed to return to the initial levels after drawdowns of increasing intensity:

2022.07.12. Steep road to recovery
Source: Craig Israelsen, Ph.D.

Note : In our example, the investment benefits from compound interest to bounce back after falling 75% in the first year.

Finally, consider the probabilities associated with the recovery time of portfolios under various drawdown scenarios (in nominal terms for the period 1970-2009):

2022.07.12.Probabilities calculated based on the historical returns of the S&P 500
Probabilities calculated from the historical returns of the S&P 500 over a 40-year period (1970-2009). Source: Craig Israelsen, Ph.D.

It becomes clear that investing in conditions of uncertainty, subject to the risk of “black swan” and, therefore, ruin, must always include an effective strategy to protect the portfolio and its composition of income.

In fact, in the previous example, if due to effective protection the drawdown could be limited to -20% (including costs), the total value after the next two years at 100% would be: 1*(1- 20%)*(1+100 %)*(1+100%) those. 3.2 – 220% yield! A result that is very different from 0% without protection.

Let’s now look at what impact a negative shock could have had on an S&P portfolio similar to that of Mr. Ronald Reid.

Take the same type of investment: S&P dividends are reinvested here from 1988 to 2021, 34 years.

Let’s take as our starting point the end value of a $100,000 investment made in 1988: $3,878,782.

Let’s now assume two scenarios for a rapid decline in early 2022: -40% and -60% and their implications for the final cost of investment. This becomes respectively: $2,327,270 and $1,551,513.

In comparison, a long-term investment simulation with systematic instantaneous protection calibrated to -20% would yield a ending value of $1,846,736. regardless of shock, -40% or -60%.

After all, isn’t that different? What about an extreme scenario? Accurate; BUT, all of these results are based on a systematic instantaneous capital protection of 80%, while non-overlapping investments run the risk of structural ruin.

So what is an overlay?

This is a highly convex portfolio protection method that aims to use liquid derivatives to achieve a given level of maximum instantaneous loss from extreme risks and significantly improve the portfolio’s return/risk ratio.

Now consider the case of an investment with an overlay that has a final return that is equivalent to that of an investment in S&P.
The initial distribution then becomes 1.5 times larger, so in our example it is $150,000. Instant Defense is still 20%, but more this time. Drawdowns are always lower than non-overlay investments due to the protection provided by the overlay.

Also, using the same logic, let’s now look for investments that can be made by calibrating them for drawdowns similar to non-overlapping investments: the initial investment can be doubled.

Then the final cost for the period 1988–2021 is becomes the following:

  • 40% Down Scenario – $3,693,472 versus $2,324,270 for the non-overlay investment.
  • 60% Down Scenario – $3,693,472 versus $1,551,513 for non-overlay investment.

And here the overlay proves its full power: it can greatly increase the distribution of equity, so that compound interest does its magic, while avoiding the risk of ruin.

Below are charts comparing various investments with and without overlay, including estimated costs.

2022.07.12.Comparison of S&P investments
Source: Ellipsis AM, Bloomberg, December 31, 2021

2022.07.12. Scenario 1
Source: Ellipsis AM, Bloomberg, December 31, 2021

2022.07.12. Scenario 2
Source: Ellipsis AM, Bloomberg, December 31, 2021

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Disclaimer related to overlay solutions: its purpose is to mitigate the risks of a particular portfolio without eliminating them entirely, and is not intended to offer any guarantee or protection for a portfolio that therefore remains at risk of capital loss. This decision is also more subject to model risk associated with the implementation of the main goal of risk reduction, which is based on a systematic principle. There is a risk that this model will be ineffective. Finally, in addition to the specific risks associated with the existing portfolio, this decision exposes the risk associated with the use of forward financial instruments, as well as operational risk. Due to the presence of hedging, potential returns may be lower due to the impact of hedging costs and the fact that the portfolio may only partially participate in growth in the event of a market recovery.

ELLIPSIS AM – 112 avenue Kleber – 75116 Paris – A Portfolio Management Company approved by AMF under number GP-11000014 – SA with a Management Board and Supervisory Board with a share capital of EUR 2,307,300 – RCS Paris 504 868 738.