Compound Interest – Myth or 8th Wonder of the World?
Einstein is credited with saying compound interest is the 8th wonder of the world. While I’m nowhere near as smart as Einstein, I have good reason to believe there is only partial truth in his statement. Specifically because of two myths surrounding compound interest that we will discuss here.
Myth #1: I will earn 7% consistently.
Mathematically, the power of compound interest is incredible. The financial industry consistently tells you to save early, save often, save (then invest) as much as you can. At an annual growth rate of 7%, you will be a millionaire at retirement. You’ve seen the graph. Just save a little each pay period, and it will growth exponentially. And they’re right…to a point.
To maximize the effects of compounding interest, two elements must exist: 1) Time. 2) Consistency.
To get the exponential growth Einstein was referring to takes years. How many years? Most likely 20+. If you are in your 20’s and methodically saving for retirement, compounding works in your favor. If you are 55 and want to retire in 10 years, it won’t help you. Most people don’t realize this until it’s too late.
Another big problem with compound growth is figuring out where you’ll get that consistent return. Interest rates are near zero and bonds aren’t returning anywhere near 7%. The stock market is the only place to achieve an annual growth rate of 7%. At least that’s what the market has delivered over the past 20 years. But does that mean you’ll get a 7% compounded return? Probably not…but, why?
The type of compounded return from the market is only seen over very long periods, at least 20 years or more. So, for long-term savings like a 401k, you can expect to achieve this type of growth as long as you leave it there. The problem is when you have to take distributions on that account. You never know what the market will be doing at that time. If it’s in a bear market, you better have another source of funds to draw from, otherwise you’ll start eating principle. This is called sequence of returns risk. You can see the grand fluctuations in the chart below.
Source: Jarred Bunch Consulting, LLC
Myth #2: It’s easy to withstand wild market fluctuations.
The other problem is whether you have the stomach to weather large drawdowns. Large, and even not-so-large, market drawdowns have a direct impact on your ability to compound returns. In the early 2000s it took several years just to get back to even. In 2008 there was such a drop that many investors sold out, just in time to lock in big losses. Withstanding wild fluctuations over a 20-year plus period is hard, very hard. You have to be true to yourself to know if you can handle it. Otherwise you’ll never see compounded returns from the market.
Why Does It Matter to You?
These are big issues for our clients. Many of whom are entrepreneurs or business owners who’ve made great sums in their businesses. While they still want to grow their investments, the overriding goal is Warren Buffet’s two rules of investing: 1) Don’t lose money. 2) Never forget rule #1.
To help our clients accomplish this we use rules-based trend following strategies. Our strategies use trends to capture upside momentum, as well as trying to limit drawdowns. This provides downside risk management with upside market potential. By providing a smoother investment ride, our investors are more likely to stick with the strategy long-term. That’s when they have a better chance to capture impressive compounded returns. That’s when they have a better chance of reaching their full financial potential.