Have you heard of compound interest? I think it comes up in just about any financial conversation when investments are involved. Compound interest is basically the concept of interest compounds on top of interest. This way you begin to get exponential returns. They start of slow but as they gain moment things really begin to take off.
The whole concept and idea of starting as early as possible is based off of compound interest. The longer money is left to compound the more compounding that occurs. This is really shown in a graph as the majority of the growth at the end happens in the latter part of the graph. This is due to the exponential growth.
You search anywhere on the Internet and they will tell you how great compound interest is. Well I’m going to take a different approach. Compound interest is just like any other financial tool. When managed properly it can be one of your best allies. However, if you aren’t aware of a few things, it can destroy your dreams. Most financial planners focus on the power and benefits of compounding interest and don’t help people understand how to protect it. From my experience, this sets people up, giving them unrealistic expectations and 20, 30 or 40 years later they are wondering where all their money is.
$10,000 at 8% over 40 years
So here are 4 things that will destroy your compound interest dreams.
2008
2008 is one of the worst down years in the stock market since the great depression. A down market can ruin your compound interest. Think of it. Just as your interest compounds on itself in positive years, in negative years not only is the principle affected but also the compounded interest. This means that as more of your money compounds and grows, you have more and more money exposed to a downturn in the market. The key here is to realize the true effect a down market has on your portfolio. If you loose 60% (as the S&P 500 did from early 2008-early 2009) it means you need to get a return of 150% to get back to where you started. Also, remember, as you look at performance numbers and you work with your financial planner/adviser Money is Not Math.
Time
Compound interest’s best friend is time. The longer time you have the the greater the growth. Something to realize for compounding interest is when the greatest growth occurs. It occurs in the last 20% of the time the money is invested. It’s pretty similar to the Pareto Principle or the 80/20 rule. In this case close to 80% of the value comes from the last 20% of the time. So what’s important about this? If you miss a year, no matter which year it is (a year in the beginning, middle or end) it all comes off the end. Think of it from the compound interest curve. If you put off investing in the beginning you loose a year off the end. If you skip a year in the middle, you loose a year off the end. If you take your money out a year early, you loos a year off the end. Are you starting to get the picture? Don’t forget that 80% of the growth occurs during the 20% of time at the end.
Taxes
I wrote a previous post related to this called, Compounding Interest, Compounding Burden. One of the certainties in life is taxes. There are only a few limited options to growth wealth tax-free. So as you utilize compounding interest it is important to manage how the taxes will affect your money. Think of it this way, just as your money is compounding if you owe taxes on it, the taxes will compound as well. In a tax-deferred account, such as retirement accounts, since taxes are paid on a percentage basis. So when your investment grows in dollar value so doesn’t the dollar value of your taxes due.
In a non retirement account the taxes get even more confusing. You then have to deal with capital gains taxes vs ordinary income taxes. The capitals gains rate is usually lower for most people because it maxes out at 15% currently. The biggest mistake most people make is they let their money compound and receive a their end of the year present, a 1099. Then they pay their tax bill out of their pocket. This leaves the money and the tax burden to continue to compound. It also takes money out of the persons pocket that could be saved, invested or spent. The compounding, in this situation, not only compounds the investment but also compounds the taxes and it compounds the out of pocket expense for the individual. If not properly aware of and accounting for these three things failure is inevitable.
Asset Allocation
I’m sure we’ve all heard of being properly diversified and how that helps spread the risk and minimize the downturn. Let’s look at how it applies to compounding interest. The mistake that people make is that they let their interest compound without rebalancing. What this means is, let’s say you start off with a 50/50 stock to bonds split, to keep things simple. Let’s assume that over time the stocks perform better than bonds, since this is what people are brainwashed to believe. The higher performance and thus, higher compounding of the stocks might cause your portfolio to become heavy in stocks. Before you know it you end up with a 60/40 or 70/30 stock to bond portfolio. Now if the stocks have a 2008 then all of a sudden instead of 50% of your portfolio taking a huge hit almost 3/4 of it does. That can make a huge difference.
What I think is a bigger mistake is the mistake that most financial planners/advisers make. I’m not really sure why they make this mistake, but what they do is preach diversification, asset allocation and rebalancing. In doing so they talk about how as you get older you should shift your portfolio to more and more conservative investments so that you are exposed to less risk. This makes sense, as your time frame decreases so doesn’t your risk tolerance because your dependence on the money is increasing. Well if you are shifting towards being more conservative it might be valid to say that you are probably going to expect a lower rate of return. Now when does this shift happen on a compound interest curve. Correct, it happens at the end. What did we learn earlier? That 80% of the growth occurs in the last 20% of the compound interest curve. So then by shifting your portfolio and getting a lower rate of return towards the end of your compound interest curve, you essentially, handicap your growth. You never get full participation in those end years when your money could really soar. Most advisers never mention this. Instead they run all their projections and analysis based off up until and sometimes, into and through retirement. The preach that as you get closer to or into retirement we will be investing more conservatively but then don’t show that. They instead set your expectations on a consistent compound interest rate that never even has the chance to occur. Does this set you up for failure?
So has these 4 things been brought up to you by friends and family? How about your trusted advisers? Or do they tend to just focus on the positives of compounding interest? What if they taught you how to manage it?
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Goes to show there isn’t really such a thing as passive investing!
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