Superimposition and the miracle of compound interest

Unlike his life, Ronald Reid’s death made headlines in 2015. How could this cleaner and gas station attendant accumulate a fortune of 8 million dollars?

Pierre Galis, Senior Overlays and Volatility Manager

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

Einstein called compound interest the 8th wonder of the world. We understand why.

For example, a similar investment 100,000 USD realized in 1988 on the S&P by reinvesting dividends would be multiplied by almost 39 times for $3,878,782.

However, for such a long period, it is interesting to study the factors that influence the final result. First, you can often hear that the average return on the stock market is 7-8% per year. For the corresponding period on the S&P, this average was even higher and amounted to 12.80%.

On the other hand, calculating the final value of an investment that has an investment return of 12.80% per year for 34 years, we get: $6,004,950 it more than 1.5 times the final value specified earlier.

Why such a difference?

In a word: due to instability. Although two investments may have the same arithmetic mean, the final value is largely dependent on volatility. Caricaturing this moment and considering three years: let’s take one year at -75%, and the next two years at +100%. The arithmetic mean is 41.7% while investment would give 1*(1-75%)*(1+100%)*(1+100%) = 1, i.e. 0% efficiency for 3 years.

Indeed, let us recall the return required to return to initial levels after downturns of increasing intensity:

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

Remark : In our example, the investment will benefit from compound interest to return to its original level after a 75% drop in the first year.

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

2022.07.12.  Probabilities calculated based on historical S&P 500 returns
Probabilities calculated based on 40 years of historical S&P 500 returns (1970–2009). Source: Craig Israelsen, Ph.D.

It becomes clear that investing in an uncertain environment, subject to the risk of a “black swan” and therefore a bust, should always include an effective strategy to protect the portfolio and its income composition.

In fact, in the previous example, if through effective protection the drawdown could be limited to -20% (including costs), the final cost after the next two years at 100% would be: 1*(1- 20 %)*(1+100% )*(1+100%) i.e. 3.2 – 220% output! A result that is very different from 0% performance without protection.

Let’s now see what effect a negative shock might have had on an S&P portfolio like Ronald Reed’s portfolio.

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

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

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

In comparison, a long-term investment simulation with a systematic instantaneous protection overlay calibrated at -20% would yield a final value of $1,846,736, regardless of the hit, -40% or -60%.

Not so different after all? What about the extreme scenario? Exact; BUT all these results are obtained by limiting the consideration of systematic instantaneous capital protection to 80%, while there is a risk of structural collapse for non-overlapping investments.

So what is overlay?

It is a method of constructing a highly convex portfolio protection that aims, through the use of liquid derivatives, to target a predetermined level of maximum instantaneous loss from extreme risks and significantly improve the return/risk ratio of the portfolio.

Now consider the case of an overlay investment that has a trailing performance equivalent to an investment in the S&P.
The initial distribution then becomes 1.5 times that, so $150,000 in our example. The instant protection is still 20%, but higher this time. The drawdown is always lower than an investment without the overlay because of the protection the overlay provides.

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

The final cost for the period 1988-2021 is then: $4,616,840 and the post-2022 decline scenarios are:

  • 40% decline scenario – $3,693,472 vs. $2,324,270 for no-stack investment
  • 60% reduction scenario – $3,693,472 vs. $1,551,513 for non-overlapping investments

And this is where the overlay proves its full power: the ability to significantly increase equity allocations to allow compound interest to work its magic while avoiding the risk of a crash.

Below are comparative graphs of various investments with and without overlay, including estimated costs.

2022.07.12.  S&P Investment Comparison
Source: Ellipsis AM, Bloomberg 12/31/2021

2022.07.12. Scenario 1
Source: Ellipsis AM, Bloomberg 12/31/2021

2022.07.12. Scenario 2
Source: Ellipsis AM, Bloomberg 12/31/2021


WARNING : this commercial document does not constitute investment advice or a recommendation to buy or sell financial products. Investors who plan to subscribe to units or shares of UCIs are advised not to base their decision solely on the elements contained in this document, but to carefully read the latest version of the prospectus and, in particular, the risk profile. UCI and KIID prospectuses are available on request from the management company or on the website: www.ellipsis-am.com. The distribution and offering of shares or units of UCI may be restricted or prohibited by law in certain jurisdictions. A UCI may not be signed or held by an Ineligible Person or an Ineligible Intermediary (see the Prospectus’ Interested Subscribers section). Before any subscription, you should check in which countries the UCIs mentioned in this document are registered.

Disclaimer for overlay solutions: its purpose is to reduce the risks of a particular portfolio without completely eliminating them, and it is not intended to offer any guarantee or protection of a portfolio which thus remains exposed to the risk of capital loss. This decision is also more exposed to model risk associated with the implementation of the main objective of risk reduction, which is based on the systematic principle. There is a risk that this model is not effective. Finally, in addition to the specific risks associated with the existing portfolio, this solution creates risks associated with the use of forward financial instruments, as well as operational risk. Due to the presence of a hedge, the potential return may be lower due to the impact of hedging costs and the fact that the portfolio may only partially participate in the growth if the market recovers.

ELLIPSIS AM – 112 avenue Kleber – 75116 Paris – Portfolio management company approved by the AMF under number GP-11000014 – SA with management board and supervisory board with authorized capital of €2,307,300 – RCS Paris 504 868 738.