Compounding and the Self-Funding Portfolio

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Albert Einstein
Aivazovsky Shipwreck, 1856, pencil and gouache on paper

Let’s say you’re 20 years old and have 40 years until retirement. If you’ve been reading this blog you know that you need to start saving and investing early to get time on your side.

You’ve also probably seen growth charts – like the one below – showing how an annual contribution of $10,000 to a portfolio that returns 6% would grow over the years. This illustrates the simple concept that time + return on investment provide exponential growth over the long run.

This is the power of compounding

Compounding describes how an investor gets returns on their initial investment plus returns on the returns on that initial investment. Returns on returns – that’s when your money starts really working for you. That’s when it takes a life of it’s own.

When contributing regularly to a retirement nest egg, there is a point after which your portfolio learns to fly on its own.

In the early days, your portfolio is small. So most of your portfolio’s growth is dependent on your contributions. During this time, investing feels like an uphill battle – it’s more an exercise in saving than generating returns. This is frustrating for many, as the dollar value of annual portfolio returns are small during this period. The vast majority of annual portfolio growth comes from your contributions.

However, over time this eventually changes. At an average annual return of 6%, portfolio returns outpace contributions by about year 13. As you can see in the chart below, once this point is passed, the portfolio becomes self-funding in a way, with the dollar value of annual portfolio returns increasingly outpacing the value of annual contributions. Of course, it is best not to think of the portfolio as self-funding, and you should keep contributing to accelerate future growth.

It isn’t until these later stages that you truly start to see the benefits of compounding.

The chart below shows the same thing as the previous chart, except it shows annual portfolio return and annual contribution as a proportion of portfolio growth. I think this really highlights why people get frustrated in the early years of investing. You can see how in the early years, the only growth is due to your own personal sacrifice. Your friends are spending their paychecks on BMW payments, while you suffer in silence to fund your portfolio with little to show for it.

However, while your friends have a negative net worth 13 years later, you’ve built a portfolio that has really started to take off.

Should You Sell Your Toronto House And Rent?

Say you’re 45 and you have $1 million of equity in a house in Toronto. Could you sell your house, invest the money and pay rent on a house solely using your portfolio?

I ran the numbers.

It costs about 3 grand to rent a house in Toronto. Assume a 6% return on a portfolio.

Here’s the plan:

Sell the house and invest the proceeds. Withdraw from the portfolio to pay your rent.

If you assume your rent increases close to the legally controlled rate (about 2%) the idea seems to work well. Between ages 45 and 90 you spend about $1.8 million on rent. But at the same time, your portfolio grows to $2.9 million. No depletion here…

Looks good, right? Keep reading…

The problem is this makes a big assumption: your rent increases actually stick to about 2% per year.

In reality, market rents in Toronto are actually rising about 10% per year. Many landlords – seeing market rents rising faster than the controlled rate – will find ways to kick out renters to jack up rents. As a renter, this means you’d likely 1) be forced to find a new house to rent every few years, and 2) experience sudden spikes in rent as you’re forced to align with market prices. Indeed, over the long term, the 2% assumption simply isn’t realistic.

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Simply increasing the rent increase assumption to 4% per year fully drains your portfolio by age 84. This is a bit more doable, although you’re f@cked if you live past 84. Also, a 4% rent increase assumption might still be low, given it’s less than half that of market rent increases.

Obviously, the story gets worse the faster rent increases. At a 10% annual increase, you’re eating cat food in your senior years. In this scenario your portfolio runs dry by age 65 – just in time for retirement!

In conclusion:

With a long-enough time horizon a $1 million portfolio isn’t enough to cover rent for the rest of your life.

Jeff Gundlach on the Next Economic Collapse

Jeff Gundlach, CEO of DoubleLine Capital predicted the election of Donald Trump and the 2007 housing crash. He is now providing insights into the next economic collapse.

Headshot of Jeff Gundlach

In 2011, he was featured as “The King of Bonds” in Barron’s, and named one of “5 Mutual Fund All-Stars” by Fortune Magazine. In 2012, he was named one of the “50 Most Influential” by Bloomberg Markets magazine. In 2013, he was named “Money Manager of the Year” by Institutional Investor.

When Jeff Gundlach speaks, people listen. Unlike most investment managers, he doesn’t hold back and is willing to tell it like he sees it. Listening to Gundlach is like getting a bucket of cold harsh reality poured on your head.

He was recently interviewed by a Swiss newspaper on what the next recession might look like. Gundlach warns investors to prepare because it will lead to big changes in the market. He argues investors need to reduce risk and own their house free and clear. (in fact, he says anyone with a mortgage should not own stocks.) While there might still be market gains over the near term, when the downturn does come people will be “overwhelmed by problems” with their investments. In particular, he sees big problems with the US corporate bond market.

“This time the liquidity is going to be very challenging in the corporate bond market. The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession. Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.”

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Gundlach also sees major problems with the US stock market, arguing it will be the worst performing equity market in the world. Why? Partly because it is currently the strongest.

“The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking. This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.”

The next recession will see deficit spending balloon. The US is already running $trillion+ deficits and this is supposed to be the best economy ever. The next recession could put upward pressure on interest rates, as demand for funding rises. Of course, the Fed will do everything in its power to combat this, but possibly not until after a crisis emerges. The firefighters don’t show up until the house is ablaze.

“Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference. He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US. You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.”

So what happens post recession when US public debt levels skyrocket due to massive deficit spending? Suddenly, the problem everyone has ignored could smack the US right in the face, and the US government will look for solutions.

You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest. …the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.”

Gundlach is not talking about a garden variety recession. This situation – massive debts, slowing growth, rising wealth inequality – has been building for decades and the world is approaching a point at which seismic shifts will occur.

This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.”

So what does normal look like?

In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened. In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.