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Underestimating compounding

We all underestimate the power of compound growth – which leads investors astray in many ways.

One common criticism of the government is that it delayed the lockdown for too long because it failed to appreciate just how quickly the coronavirus would spread – a daily R0 of two means that one case becomes more than 16,000 within a fortnight. One scientific adviser says the Sage group “were not sure the politicians understood its exponential spread”.

This accusation is plausible because it is a common error to underestimate the power of compound growth. The late Albert Allen Bartlett, a physics professor at Columbia University, said: “The greatest shortcoming of the human race is our inability to understand the exponential function.” He was exaggerating: there’s plenty of competition for the title of the greatest shortcoming of the human race. But he had a point. And it is a shortcoming that can cost investors dearly.

For one thing, underestimating the power of compounding causes us to underestimate the importance of reinvesting dividends. Since December 1999 the All-Share index has risen a mere 1 per cent. But if you had reinvested your dividends from it, you would have doubled your money. Even low exponents multiply a lot over time.

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