FIRST: a little bit of education. Compound returns. Definition of a 10 per cent compound return. Take a dollar. In the first year, you earn 10 per cent. At the end of the year it's worth $1.10. In the second year, you earn another 10 per cent. Now it's worth 10 per cent more, or $1.21. In the third year earn another 10 per cent. Now it's worth $1.33. And so on. A compound return is what you earn when you leave all the returns in the investment and the returns earn returns.
As noted last week, the oft-quoted average compound return in the sharemarket is 9.5 per cent a year. Let's assume that's right and compound a dollar on that basis. We'll forget about dividends. We'll concentrate on capital.
So, we invest a dollar at 9.5 per cent a year. After the first year its worth $1.095. Year two $1.199. Keep that going for nine years and it becomes worth $2.066. Twelve years from the start our $1 investment becomes $3. In other words, at 9.5 per cent a year in the sharemarket, you double your money every nine years and triple it in 12.
Let's take this over the long term. If you took one dollar on June 30, 1937, 72 years ago, invested and compounded it at 9.5 per cent a year for 72 years, then as of June 30, 2009, it was worth $688. Cripes. Invested in the All Ords Index, $10,000 in 1937 would now be worth $6.88 million. Wow, let's all buy equities and hold on forever. How simple the investment game is. Invest for the long term. No brains required. Fantastic.
Except for one little problem. Tempting as it is to plough all our money into equities forever and remove brains, there is a question someone has to answer. If $1 compounded at the average return of 9.5 per cent for 72 years turns into $688, then why has $1 invested in the All Ords on June 30, 1937, actually only turned into $51.39?
What? It's supposed to be worth $688 $51.39 is only one 13th of $688. Are you telling me the average return isn't 9.5 per cent a year after all?
Well, yes.
Work it back and the actual compound return the All Ords Index has delivered since 1937 is 5.62 per cent - and at that rate, you don't double your money every six years and triple it every nine you double it every 13 years and triple it every 20.
And there's more.
The All Ords Index is a fudge. It is not reality. It performs better than reality because it constantly replaces all the bad stocks with good stocks. The All Ords index is like running a residential property price index using only the houses in Toorak and Brighton and if any of them fall in value you chuck 'em out and put in a better one. On that basis, to keep up with the All Ords you would have to do what it does: constantly prune and replace. Bit boring. Might have to use brain after all.
Then there are transaction costs, of course. The index doesn't pay transaction costs. They just move holdings around, free. Now we're eating into our 5.62 per cent. Then there's inflation, what about inflation? Have to take that off as well, I suppose. That's conservatively another 1.5 per cent a year. Then there's tax. Forgot about that. The index doesn't pay tax. We do. Bugger.
Suddenly even 5.62 per cent is looking a bit optimistic and we still haven't deducted for "life costs" - the cost of our time and the stress from having to ignore the family in the evenings and at weekends while we frig about.
All in all, 9.5 per cent is a bit of a joke and the marketing of long-term returns is inaccurate because it is unrealistic in terms of actual post-tax returns.
Moral: There is plenty of money to be made in shares, but you have to buy individual stocks that go up and if you insist on buying "the market" you have to "time" it, not just sit in it with your head in the sand. You have to do better than that. You have to avoid the crashes. The time to "invest" is not all the time, it's when the market is going up. There is no free lunch by just investing without brains. Amazing really that half the industry thinks otherwise.
Marcus Padley is a stockbroker with Patersons Securities and the author of the daily sharemarket newsletter Marcus Today.
marcustoday.com.au
Frequently Asked Questions about this Article…
What is a compound return and how does compounding work for long‑term investors?
A compound return is when you leave investment gains in the investment so those gains themselves start earning returns. For example, at 10% compound return $1 becomes $1.10 after year one, $1.21 after year two, and so on — compounding accelerates growth the longer you stay invested.
Why do people often quote a 9.5% average sharemarket return and what does that mean?
The oft‑quoted 9.5% figure is an average long‑term nominal return used to illustrate compounding: compounding $1 at 9.5% for 72 years would grow to about $688. It’s a marketing shorthand that shows the power of time and compounding, but it doesn’t account for real‑world frictions like taxes, inflation or index measurement quirks.
What is the actual historical compound return of the All Ordinaries (All Ords) index since 1937?
According to the article, the All Ordinaries Index has delivered an actual compound return of about 5.62% per year since 1937 — much lower than the 9.5% example — which translates into doubling roughly every 13 years and tripling roughly every 20 years.
Why is there a big gap between the 9.5% example and the All Ords' 5.62% return?
The gap comes from several factors the simple 9.5% example ignores: the All Ords index benefits from replacing poor performers with better stocks (a survivorship/reconstitution effect), and real investors face transaction costs, inflation (the article mentions about 1.5% conservatively), taxes and other personal costs — all of which reduce actual post‑tax returns.
Does the All Ords index reflect what an ordinary investor would have earned if they simply 'bought the market'?
Not exactly. The article describes the All Ords as a ‘fudge’ because it constantly prunes underperformers and adds better stocks without incurring transaction costs or taxes — things a real investor would face. To truly match the index you’d need to constantly replace holdings and absorb trading costs, which can be boring and costly.
Should everyday investors just buy the market and hold forever according to this article?
The article warns against blindly buying the market and forgetting about it. It argues you either need to pick individual stocks that outperform or be prepared to time the market to avoid crashes; simply sitting in the market ‘with your head in the sand’ won’t necessarily give realistic post‑tax returns.
How do transaction costs, inflation and taxes affect long‑term stock market returns?
Transaction costs, inflation and taxes all reduce the headline compound return. The article points out the index doesn’t pay transaction costs or taxes and suggests inflation (roughly 1.5% in the article’s example) and taxes should be deducted from nominal returns, making advertised long‑term returns look optimistic for individual investors.
Who wrote this commentary and what perspective does it bring for investors?
The piece is by Marcus Padley, a stockbroker with Patersons Securities and author of the Marcus Today newsletter. His perspective emphasizes realism about long‑term returns, the limitations of index figures, and the need for active decision‑making (stock selection or timing) if you want to outperform the market.
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