Albert Einstein is credited with calling compound interest the '8th Wonder of the World.' A beautiful illustration of this phenomenon is the long-term growth of stock prices over the past two centuries—an inexorable march from the lower left to the upper right.

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But at this scale, the chart masks a stern warning. Within a typical human lifetime, investors have experienced irrecoverable losses and decades of flat returns. Nor can the chart capture the emotional toll market swings can inflict. None of us can choose the era in which we live, earn, and invest; we can only hope that good fortune places us on the chart’s smoothest, steepest climbs. The true secret to compounding wealth, however, has less to do with luck—or even complex finance—and far more to do with simple arithmetic.

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The three biggest obstacles investors face in compounding wealth are: 

• Wild market swings (volatility); 
• Significant drawdowns (major losses); and 
• Income taxes.

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A violent roller coaster

The ups and downs in a portfolio’s value are collectively called volatility, and their impact on long-term returns is often referred to as volatility drag. While the math behind how volatility affects compounding can get complex, the basic idea is straightforward:

Consider the three-year returns of two hypothetical portfolios: which would you rather own?

Many investors might assume Portfolio B is the clear winner—after all, it posted an impressive 30% gain in year one and outperformed in two of the three years. Others may see the same 5% average return in both portfolios and assume they delivered equal results. However, the actual Compounded Annual Growth Rate (CAGR)—the true measure of what an investor earned on every dollar invested as it moved through the ups and downs—tells a different story.

The CAGR of Portfolio A matches its average return at 5%, while Portfolio B compounds at just 2.36%.

In other words, Portfolio B’s higher volatility reduces its effective returns by more than half. This illustrates how lower volatility can lead to stronger long-term growth.

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The Big Dip: why large drawdowns (major losses) are the enemy

Large drawdowns, often a product of high volatility, may be the single biggest headwind to compounding.  While our hypothetical example used a 25% drawdown, real-world investors have faced far worse:

• Multiple 50%+ drops: this century alone has seen steep declines of 50%+ during the Dot-Com Bubble (2000–2002) and the Global Financial Crisis (2008–2009).
  
  
• Several significant declines over 25%: even in the past few years markets have experienced notable pullbacks, including the COVID Crash (2020) and rate-hike concerns (2022).
  
  
• Extreme downturns: some markets suffered even deeper losses: for example, the Nasdaq tumbled over 82% when the Dot-Com Bubble burst.

Unfortunately, these major drops often come on the heels of periods of surging prices and optimistic headlines—exactly when everyday investors tend to pile in– making the eventual plunge even more devastating.

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Why are such drawdowns so damaging?

While smaller fluctuations may be mere noise, major drawdowns leave lasting damage, demanding far greater gains to break even:

The asymmetry of returns means that as a percentage of the portfolio, a loss hurts more than a gain of equal magnitude helps. Even worse, if you need to withdraw funds when your portfolio is already down, a portion of the losses is irrecoverable. Minimizing both volatility and drawdowns is therefore essential to preserving capital and compounding over time.

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The Cure: Meaningful Diversification

Diversification is an investor’s best defense against both “volatility gremlins” and the disproportionate impact of large losses. However, not all diversification is created equal. Many assets appear or sound different, but fail to perform when needed most.  As an example, small-cap, mid-cap, and large-cap stocks sound like different asset classes, but they will all tend to move in lockstep during major market declines.

But, the most effective diversifiers can be difficult to own—not just because they sometimes struggle, but because by their very nature they will often lag when conventional assets are thriving. Yet that is precisely what makes them valuable, helping portfolios grow more steadily as market tides shift.

Meaningful diversification requires pairing asset classes or strategies that actually behave differently in different economic environments, and thereby protect a portfolio from large drawdowns. If all your investments rise together, they are likely to fall together. A well-diversified portfolio benefits when different components perform well at different times—producing steadier, stronger long-term returns.

An investment program that combines assets with meaningfully different return patterns—and actively rebalances—does more than smooth the ride; it can enhance returns as well. Rebalancing between assets that zig and zag at different times acts as a built-in mechanism for systematically buying low and selling high. Over time, these incremental gains compound, allowing a well-structured portfolio to generate higher returns than any of its individual components.

If this seems counterintuitive, you're not alone: this is a principle that applies beyond investing. Consider the lessons from The Farmer’s Fable, which illustrates how balance and reallocation create outsized rewards in nature, economics, and beyond.

Of course, true diversification requires a commitment to a strategy that will inevitably appear out of sync with mainstream portfolios at times. There will be stretches where one or more components lag while traditional portfolios appear to be thriving. But over time, this discipline is what allows a portfolio to weather uncertainty, adapt to different environments, and continue to compound your wealth through market cycles. Still, not every obstacle to compounding can be mitigated through portfolio design. Some forces quietly erode wealth no matter how well a portfolio is built.

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The (almost) unavoidable drag on compounding: taxes

Like volatility and drawdowns, taxes erode compounding by siphoning away returns before they even have a chance to materialize.in Every dollar claimed by your silent partner—the Government—is a dollar that never gets a chance to grow on your behalf. In high-tax states, Federal, State and local levies can chip away as much as 50% or more of your investment gains, delivering a significant blow to long-term compounding.

The best defense against tax drag is incorporating a well-designed, proactive strategy –one that helps you keep more of what you earn and ensures it keeps compounding.   Elements of such a strategy include:

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• Prioritizing tax-efficient investments to reduce taxable income.
  
  

• Strategically placing assets in appropriate account types to optimize tax treatment.
  
  

• Leveraging advanced tax strategies like tax-loss harvesting and specialized exchange programs to minimize, defer or eliminate unnecessary taxes.

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Tax management isn’t just about paying less today: it’s about keeping more capital invested and compounding for decades to come. A tax-aware portfolio ensures that investors can keep more of their returns, maximizing after-tax growth and compounding wealth more efficiently over time.

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Looking Ahead: compounding in an uncertain future

Investors in the past few decades have benefited from powerful tailwinds: soaring valuations, falling interest rates, and investment costs that have shrunk to near zero. These forces have delivered powerful returns to a broad range of investors, but the drivers of this wealth creation suggest that gains from here will be harder to achieve. 

While predicting the future is impossible, building a portfolio that minimizes volatility, avoids deep drawdowns, and manages taxes efficiently provides the strongest foundation for long-term compounding—regardless of what comes next.

That’s why constructing Better portfolios—our first step toward creating Better, Bigger, and Broader solutions—brings greater diversification and higher efficiency. We invite you to learn more about Better Portfolios here.

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