Building Blocks

Power of Compounding

 

 

Two Levers to Wealth

  • “Compound interest is the eighth wonder of the world.  He who understands it earns it.  He who does not pays it.”
  • “The power of compound interest is the most powerful force in the universe.”

– Albert Einstein

     The average investor has two key levers for wealth accumulation.  Together, they are nearly unstoppable, and are known in conjunction as compound interest.  Time and return together form this opportunity.  To the investor with financial discipline and a knowledge of both, wealth accumulation is a foregone conclusion.

     Neither lever requires an over-abundance.  One must not live for 100 years nor must one achieve 20% annual returns.  In the game of wealth accumulation, moderation and activity at a slow and steady pace will win the game.

Return

     The rate of return is the net gain or loss of an investment over a time period, expressed as a percentage of the investment’s initial cost.  When calculating the rate of return, you are determining the percentage change from the beginning of the period until the end.

     The most common time period for evaluation a rate of return is over a one-year time frame, called the annual rate of return.  A few estimated annual return rates for various financial instruments:

  • Risk-Free Rate (10-Yr Treasury): ~1-3%
  • Bonds: ~5%
  • Stock Market: ~9-10%

     Note that the values above are average annual returns.  The range for each investment product may fluctuate significantly from year to year.

Time

     Time acts as the greatest asset for wealth accumulation.  Not only does it empower compound interest, but it also reduces the volatility of annual returns, especially for investments with higher average return rates.

     In assessing the time over which compounding can occur, every incremental period of compounding can provide exponential returns.

     For simplistic math, assume a 10% annual rate of return and a $1000 investment.

*Note: A $6500 investment for a newborn may grow into a $5 million nest egg for the child by age 70! 

*Rule of Thumb: The Rule of 72 estimates the time period for an investment to double with interest at 6-10%.  The time (years) for an investment to double under compound interest is approximately 72 / interest rate.

While a single lump sum investment provides astounding results over long periods, a commitment to consistent, disciplined investing offers great results with self-empowerment.

     (Few of us have the wherewithal to invest a few thousand dollars before we can walk.)

     Assume a moderate 8% annual rate of return.

image from www.artofmanliness.com

     Investing in assets with higher rates of return coincides with assuming greater risk and volatility in those returns.  Consider the annual returns of the S&P 500:

     In short time frames, the S&P 500 has periods of poor performance.  However, with a long-term horizon (such as 20 years in the chart below), the S&P 500 has never failed to perform over the past 100 years.

source: Crestmont Research

Coordination

     Compounding provides wealth for investors who know its dual levers of return and time, and who can coordinate both to execute a financial plan.  Invest …

     Conservatively – understand your investment vehicle / underlying

     Early – procrastination eliminates the most profitable return years

     Long-term – shorter periods provide greater return risk

source: Maurie Blackman, The Motley Fool

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Risk-Free Returns

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Power of Compounding

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S&P 500 Index

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Preferred Tax Treatment

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Dollar Cost Averaging