Today, I want to teach you about one of the greatest tools used to create wealth
Compound interest is something that we are taught in school. The instructor gives an example of your saving $100 per month and at the end of 1 year at 10% interest compounded monthly, that instead of having $1200, you would end up with $1,267.03.
If you were to continue to invest $100 month after month, after 10 years instead of being $12,000 it would grow to $20,655.20.
Now is where the instructor gets really excited as he asks, what do you suppose would happen to your $100 monthly deposit if you continued to receive a 10% annual return compounded monthly after 30 years? The answer? Well let’s figure it out. Enter the data in this simple
What did you get? I bet you were surprised! My answer was $227,932.53! That’s a lot of money for sure, but I have some questions for you…
- Are you saving $100 per month?
- Are you getting a consistent 10% annual return compounded monthly?
HERE’S WHAT YOUR TEACHER DOESN’T TELL YOU!
What he won’t tell you is that if you ever lose, that these losses will always cost more than your gains if you are compounding. This is true regardless of when and where the losses occur. Now it’s interesting to me that I cannot find a simple compounding calculator that allows for the entry of negative returns...hmmm, I wonder why?
So let’s keep it simple then and just look at annual returns compounded annually rather than monthly. Let’s further simplify the example by just investing $1,000 on the first of every year.
If you invest $1,000 and earn a 10% annual return after one year, you end up with $1,100. But what if you lose 10% the next year from what you are investing? Would that simply cancel out what you earned the first year? That’s what your financial advisors tell you...they say that your average annual return is 0%. That’s true, but let’s take a look at what you are actually left with after a second year loss of 10% after compounding your returns...
$1,100 + $1,000 new capital invested January 1st = $2,100 * (10%) = $1890!
If you lose 10% the second year, you end up with how much? Only $1,890! That’s actually a loss of $110 over two years. That’s less than you’ve invested! Let’s take a look at the returns over two years then…
$1,890/$2,000 = 94.5% of you invested capital or a loss of 5.5%!
What if you reversed the order, does anything change? If you try this for yourself, you’ll find it doesn’t matter when or where the losses occur. So here is the take-away lesson…
Losses ALWAYS count for more than gains REGARDLESS of when and where they occur WHEN compounding is involved!
This shortcoming of compound interest is seldom discussed by financial advisors...why? Because if they told you the truth, you wouldn’t want to invest with them or certainly not in the market!
So if not in the market, where else can you find a place to put your money to work for you that doesn’t risk loss? CD’s? Bonds? Fixed Income Securities? What is the return on these types of investments? Generally, the returns are quite low...less than 3% return per year. If these fixed income investments never lose, they will end up beating the average returns of investors who risk their capital in the market due to the additive effect of compounding.
If you never lose, then compounding becomes EXTREMELY POWERFUL! Take a look at the video below to see what can happen when compounding returns without loss!
So why am I telling you all of this? Because if you don’t understand the downside risk of compounded returns, you are likely to make a very costly mistake. I believe you want to be in better control of your money, your future and the future of your family.