How Compound Interest Can Help Build Wealth

Sign of the Times
October 4, 2017
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How Compound Interest Can Help Build Wealth

“Winning the lottery is crucial to my retirement plan.”

Does it surprise you to hear that this is a real quote from an American worker? Sadly, it’s not just one person’s perspective. It’s a sentiment that is shared by the 40-50% of Americans who believe that winning the lottery is the only way they can get what they need for retirement.

The odds of winning a Powerball have recently been calculated to be 1 in 292,000,000. As a financial advisor, I am frustrated by an investment strategy that is based on a verifiably unrealistic longshot. That frustration is only compounded by the fact that there is a simple solution! The real winning ticket to ensure you can live comfortably in retirement is not a lottery ticket, but rather a concept you likely have heard of but brushed aside: compound interest.

It’s Been Said That Albert Einstein Called Compound Interest the Eighth Wonder of the World

And even if he didn’t, it’s still a brilliant investing tool. Simply put, compounding is a process which generates additional return on an asset’s reinvested earnings. To be effective, it requires two simple things: the reinvestment of earnings, and time. If properly managed, compound interest can help your initial investment grow exponentially. For those of you who enjoy math, here’s the formula:

Ending $$ = Beginning $$ * (1 + return) ^ total time frame of compounding

While this is a useful strategy for all investors, for young investors in particular, it is the greatest investing tool for long-term growth, and the #1 argument in support of starting as early as possible. Just look at the graph below, which represents the growth of $100 over 30 years:

 

You can see that without reinvestment, the return potential is significantly reduced no matter what the rate of return is. This is important to understand because many investors are tempted to capitalize on their gains too early. The results reflected in this graph make it clear that choosing to instead reinvest those gains is going to make a significant difference in the long run.

The best advice for how to implement this strategy and maximize your long-run returns is to (1) postpone gains, and (2) rebalance efficiently. When tempted to take a short-term gain, always ask yourself: do you really need to sell? If not, don’t. Committing to a long-range investment strategy will make a world of difference in your returns. And when rebalancing, instead of creating a tax event by taking gains, consider allocating future proceeds into holdings that have underperformed.

Compounding interest becomes more complicated when the effect of taxes is factored in. Investors are often not able to reinvest all of the money that has been paid out because the government takes its cut. In order to get around this, you should try to minimize the effects of taxes by putting money into tax efficient accounts; ensuring that tax inefficient assets/strategies are in kept in retirement accounts; allocating assets to tax efficient areas of the market such as municipal bonds and real estate; and utilizing ETFs to delay tax events for stock holdings.

You don’t have to be Einstein to understand the power of compounding interest. Instead of putting your fate in the hands of the lottery, take control of your retirement plan through smart, well-thought-out investment decisions. If you have any questions, don’t hesitate to reach out to us here.