One of the limited downsides to being an investor is that we tend to convince ourselves over time we are smarter than the market. This is one of the most dangerous mindsets to have alongside the belief we can fight the Fed or outperform the market consistently. It is almost impossible due to various unknowns. Might as well tell a monkey to throw darts at random stock picks. Surprisingly, your returns can turn out better with a small margin of error.
For the longest time, since I started investing, I’ve heard this term, “compound interest” thrown around. Truthfully, I didn’t want to ask what it meant since as an investor, I needed to display confidence with my investment choices otherwise, I felt I wasn’t qualified to be invested.
That was a big mistake. The market is made for everyone at any stage and it is a learning process. No one knows everything, even top traders who cannot define compound interest!
Surprisingly, I noticed very few people actually know what COMPOUND INTEREST entails.
Do you?
It’s okay if not. Most experienced investors don’t either since it won’t necessarily make or break one’s returns as it works behind the scenes anyway.
It sounds fancy and must be important since Warren mentions it all the time.
He even refers it to the“eighth wonder of the world” as some mystical force!
Compounded Interest in Compound Interest
Compound interest means what it sounds like.
It compounds the interest we earn on our investments. This isn’t complicated and by far the easiest thing to learn when it comes to investing.
But how does it actually work?
The Mechanics Behind Compound Interest
Compound interest is where you reinvest earned interest — which then earns additional interest.
Interest is reinvested money made on the initial deposit and this is backed by the system of compound interest. With only a few dollars, thanks to compound interest, you can see that birthday money COMPOUND to as high as you can imagine. With patience, diversification, and luck, compound interest is your best friend.
Since time is our most precious advantage in the markets, compounding works the best the longer our money is invested due to DCA (dollar-cost averaging), recurring payments instead of lump-sum deposits.
Once you routinely contribute to your portfolio, you obviously hope for your holdings to grow. Although dozens of factors go into a company’s share price and what’s certain is volatility, compound interest helps stabilize returns long-term. The longer you stay invested, the likelier your annual returns will be higher as well.
Compounding isn’t about shoving more money into the stock market and seeing it grow in value. It is about reinvesting those gains consistently over time.
Think of COMPOUNDING and CONSISTENCY as a joint system. Your money will not only be able to withstand more volatility, but you will be able to fund and live your lifestyle without feeling pressured to invest all of your take-home pay. Contrary to popular belief, investing consistently in moderate amounts over time is much better for your lifestyle and portfolio long-term so you don’t feel depleted investing it all away. Also, your holdings won’t need to constantly be rebalanced and sold making it advantageous for tax purposes.
Whether it be through dividends, a quarterly cash payment that is given to shareholders from a company that ends up being reinvested back into the market, or routinely investing, compound interest is the building block behind these concepts.
Let’s say you invest $1,000 at 6% interest. At the end of the first year, you receive a $60 interest payment. In the second year, you earn 6% on the $1000 and 6% on the $60, making $63.60 in total. In the third year, the interest you earn increases to $67.42. You earn interest on interest each year.
What fuels compounding?
Time.
Time is exponential and so is growth. Eventually, major broader indexes do go up over time and compound interest works best when you are invested passively through a buy and hold strategy. This builds momentum and most importantly gains grow exponentially this way.
Next time you hear compound interest on the news or in the newspaper, if you still read it, you can pat yourself on the back for finally understanding a topic that seemed too silly to look up in the first place.
We can thank compound interest for killing it this year.