The Myth of Compound Interest
Compound interest is worthless if there's nothing to compound. In other words, the importance of compound interest is secondary to how much a person saves and how often.
Take a closer look at compound-interest growth charts. Find where they account for taxes on the chart. They don't? How about fees and commissions? Nothing? What about inflation? Suddenly the chart is looking a lot fuzzier, isn't it? Accounting for taxes, commission, fees, and inflation is an integral part of responsible investing, and counting on compound interest alone to negate all these factors is just plain foolish.
Most of these charts also base their estimates on a return averaging upwards of 10%. That's misleading. To see why, let's use the example of the number so frequently cited as the average annual return of the S&P 500 index, which is 10.7%. When we see this number, we think to match the market average, our investments should mature, or compound, at a rate of 10.7% per year. But what we're neglecting to consider is how that average is figured. The market may surge to one and a half times its value in a booming bull market and then for the next three bearish years drop by 20% per annum.
That's how the market "gains" an average of 10.7% per year - by gaining and losing in fits and starts and then calculating the average over a period of 15-25 years of that. But what if you started investing right before the market took a serious nosedive or simply flat-lined for a number of years? How the heck is compound interest going to help you make money then? And, heaven forbid, what if one of these negative periods occurred shortly before you were planning on withdrawing some money from that investment for personal use - a bigger home for your family, a daughter's wedding, a new baby, retirement?
You need a more comprehensive strategy than simply relying on compound interest to protect and compound your savings when the market turns, when interest rates decline, and/or when certain investments turn sour.
Another point to consider is the index being used to convince you of the viability of particular investment or investment strategy. If, for example, instead of using the S&P 500 as an index, you used the Dow Jones Industrial Average, your average annual return for the last half-century would be less than 5%. Try and build a retirement savings on that!
Whichever index you utilize in approximating average returns on an investment is misleading without taking those other above-mentioned factors into account. If your investments, for example, are not in an IRA, 401K, or other tax deferred account, you'll have to subtract 18-35% off your expected gain for taxes.
And if you think taxes are bad now, just wait until the next decade when social security is drained by the aging baby boomers and the government is "forced" to raise taxes to compensate. Then all your hard work and sacrifice will have amounted to much less than you had hoped for. It could threaten all the future plans you made for yourself based on what you thought were such careful calculations.
Certainly most of the big-name financial gurus will espouse the tax benefits of certain "qualified accounts," but too often they neglect to go into detail on how difficult it may be for different people to qualify for these programs. All sorts of rules and restrictions are in place for each of these so-called investment savvy types of accounts that limit the actual potential gain - restrictions such as caps on new money that can be invested per year, ceilings on how much can invested overall, and tight restrictions on who can and cannot qualify for such investments.
The real and reliable gain from compound interest alone comes when the money in question has been sitting in an interest-bearing account for 35 years or more. So for a 5 year-old investing $25,000 with no plans of withdrawing a dime of it until her grandchildren are out of high school, compound interest will work like a charm. But life happens, and we all know it. And it oftentimes takes a lot more than discipline to keep money in the bank.
Consider that over 40 percent of people 55 years and older have less than $50,000 in liquid assets. Then consider that an average 65-year-old retired person needs $1 million in the bank to continue living the lifestyle they've grown accustomed to prior to retirement.
The best way to compound your own savings is to add to it yourself, dutifully, diligently. This requires a detailed budget. Software programs, like Budget Forecaster by Strativia Software, can help you come up with a savings plan that you can realistically and consistently stick to if you want to take responsibility for compounding your own money rather than leaving it to chance.
Beyond that, continue adding to your investment knowledge and building on your investing skills. There's no shortcut to wealth, but it's also not rocket science. You simply need to save whatever you can, even if it's only a little at a time, and keeping it earning a rate of return that's higher than inflation.
Kenneth C. Kelly is the President of Strativia, a financial management software development and services company specializing in applications for personal and business use. Strativia is the developer of Budget Forecaster, a sophisticated home budget and personal finance management software package. Website: www.strativia.com. Contact: info@strativia.com.
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