The performance of an investment can be determined in many different ways. When you put money in the bank at a set interest rate, the math is easy. You can find all sorts of handy interest calculators online. Things can get a lot more complicated when the value of a security goes up and down over time as do stocks. Let’s look at the bank example, and once again revel in the majesty of compounding interest. To make the math easy, let’s say you have found the most awesome bank ever and you are earning 10% per year on your deposit of $1000. Your investment results over five years would look like this:
- Year 1: $1,000 x 10% = $1,100
- Year 2: $1,100 x 10% = $1,210
- Year 3: $1,210 x 10% = $1,331
- Year 4: $1,331 x 10% = $1,464
- Year 5: $1,464 x 10% = $1,611
Most securities don’t pay a nice flat rate like banks do. Asset prices fluctuate because of market volatility (much more on volatility later) and periodic dividend or interest payments, depending on the type of security. Unlike banks, the stock market really does pay about 10% per year on average, but it can fluctuate widely from year to year. You may lose 10% one year and be up 20% the next year. When things get complicated like that, most investors look at the compound return on the investment.
The compound return of an investment tells you the constant interest rate you would have needed to get the same result you achieved in a variable market. This is important because taking the average of yearly returns over the same period results in an often-severe overestimation of the rate of return. Beware of investments that tout a high average annual rate of return. What you really want to know is the compound rate.
The Wall Street Animal Farm
Elephants: Renowned investor Warren Buffett made the phrase “hunting elephants” famous in referring to a huge deal.
Unicorn: This term is used to refer to something unusual or scarce. Investors like Warren Buffet that can consistently beat the return of the overall market are said to be “unicorns.” The term is also applied to small companies that have explosive growth, making early investors enormous profits.
Bear: This term can be used to refer to an adverse market where prices are falling or a person that has a negative view of an individual security or the market in general. If you are bearish on oil, it means you will believe that the price of oil is going lower.
Bull: The term can be used to refer to a positive market where prices are rising, or a person that believes that a particular security or the overall market will continue to rise. If you are bullish in IBM, you believe that IBM will increase and price.
Dog: A security with a poor performance.
Pig: A pig is an investor who puts greed ahead of sound investment principles or sound strategies. Anyone who watches stock guru Jim Cramer knows one of his most famous expressions: “Bulls make money, bears make money, and pigs get slaughtered.”
Sheep: A sheep is an investor who has no strategy to speak of. This type of person listens to others for financial advice and often misses the most meaningful moves in the market.
The Magic of Compounding
Behavioral economics tells us that many people fail to invest because they don’t understand how much money they can make. According to a USA Today, 66% of Americans don’t understand compounding. This helps to explain why American workers are in such deep trouble when it comes to retirement. Without compounding, you’d end up eating cat food in a cold house with no electricity. As Albert Einstein reportedly said, “Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.”
I am an unapologetic supporter of the idea that debt is evil and is to be avoided at all costs. The reason that you can’t ever get those credit cards paid off is that you are paying compound interest to the credit card company, just as Einstein predicted. You can easily be trapped in an endless spiral of debt if you aren’t very careful. The path to retiring wealthy is accessible; all you have to do is earn compound interest and not pay it.
Some detractors do not agree with the fact that compounding is magical. They point out that compound returns are simultaneously eroded by fees, inflation, taxes, market performance, and the other ways you could spend your money. This doesn’t mean that you can’t get rich through the process of compounding; it just means that you must take great care to plant the seeds of your wealth in a fertile field. In the balance of this book, we will learn how to combat the worst of these ills.
We will invest in tax-sheltered retirement accounts, and pay no taxes on our profits (until we retire) so that compounding can really shine. We’ll take advantage of employer matches such that we make a 100% return the very first day we invest. We’ll develop a strategy that beats inflation to the degree that compounding grows our actual buying power over time. We’ll learn strategies to minimize market risks so that we actually get the returns that we expect. We will use low-cost index mutual funds to reduce fees. All of these factors are critical, and we can’t control some of them. Still, you can indeed retire wealthy through diligent savings, intelligent investing, and the magic of compounding.
This fantastic magical process isn’t all that complicated. The idea is that you can capture investment returns not only on the amount you save but also on the investment returns. As your savings grow exponentially, you get even more returns on your ever-expanding portfolio. This sounds like an additive process where you gain a little extra money. Compounding works so well because the growth of your money is geometric, not linear. When you are setting up an investment account, your broker will likely ask you what you want to do with earnings from dividend and coupon payments: The answer is always to reinvest them. Some brokerage firms will have clever acronyms for this, such as D.R.I.P., which stands for dividend reinvestment program.
My favorite way to illustrate how compounding works is with the magic penny analogy. Would you rather receive $1 million today or earn a penny that gets doubled every day for a month? It may seem counterintuitive, but if you choose the $1 million, you are making an excruciating financial mistake. A penny doubled every day for a month (31 days) compounds to around $10.7 million.
In this far-fetched example, you would have to invest in an instrument that paid 100% interest daily. That sort of return is fantasy, but it demonstrates the point. If you are feeling industrious, set up a spreadsheet and do the math. You will notice some important points. On day 10, with a third of the month gone, you are only making $5.12 per day. The lesson here is that when you start out small, it takes a long time to start really making the big bucks. This means that you need to start investing as early as possible, like with your first paycheck.
You will break $1,300 on day 18, and it seems like the momentum really picks up. This is what I mean by geometric growth. If we get the spreadsheet to generate a line graph, we’ll find that the relatively straight line bends upward and takes off like a rocket ship at some point. We call it geometric because of the mathematical function used to calculate the return. You are raising the base amount to a power rather than just adding something to it. Of course, with real investments, interest isn’t 100%, and it doesn’t compound every single day.
Think back to our original question. Unless you’ve heard of the magic penny before, you almost certainly chose to take the $1 Million. This is because the human mind doesn’t think in geometric terms. Those parabolic lines just don’t represent reality for us, so we need to do the math and maybe even a graph before we are suitably impressed. Perhaps that is the reason that Einstein held compounding in such high regard; he was a mathematical genius and likely could think in geometric terms. The bottom line is that if you invest 10% of a $30,000 salary and get an employer match, you can retire in 40 years with around $1.5 Million in your retirement account, and that is assuming you never get a raise, and you only earn 8% interest.
You probably already noticed the downside: You have to wait for a very long time for this to work. The higher your rate of return, the faster it works. The more you start with, the quicker it works. Ideally, your rich uncle will give you $250,000 on your 21st birthday for you to invest along with your 10% contribution. Invested at 10%, you’d hit the millionaire mark in just a little over 14 years. Sadly, most of us have no such rich uncle. We have to get rich the old fashion way–very, very slowly.