Lessons of Compound Interest:Interest Rates Matter!

 A seemingly small change in interest rates makes a  huge difference in the long term returns of your investments.  To get the most from compound interest you need to pay close attention to the rates of return of your investments.  There are so many possible ways to increase returns that I only want to touch on the major factors here.

Reasonable Risk

If you speculate wildly or stuff your money in a mattress you are likely to end up with far less than taking calculated risks.

Safety in Numbers

Buying individual stocks is always riskier than buying a group of stocks. What are the chances that a single company will fail and lose all of it’s value? Now consider what are the chances that a group of 500 companies will?  The down side is that a single company may grow by leaps and bounds while the average of 500 aren’t nearly as likely.  If you bet all your retirement savings on the fortunes of one company you may end up very rich… you may also end up eating cat food during retirement.  I think most people are better served accepting the average market return rather than gambling on a single company.   Mutual funds offer a way to buy large collections of companies, without the trouble and expenses of hundreds of transactions.

Thinking Long Term

The last few years have been pretty brutal for the stock market, but that is over a short term.   If you look at longer terms say- 20 years or more diverse collections of stocks have done very well. Take a look at this table at All Financial Matters, showing the returns from the S&P500, a group of stocks of the 500 largest companies traded in the US.  Note many of the 20 year periods the returns from the S&P500 have had average compound returns of 10% or more. Even considering the terrible performance of stocks in 2008, over the last 20 years the SP&P500 still had a 8.41% average growth rate. The future is never certain, but I don’t believe the economy is in a death spiral and will never recover.  I think it makes some sense to invest in both stocks and bonds.

Don’t be Taxed by Taxes

Is there anything worse than making sacrifices to invest then giving a large portion of the return to the tax man? If you don’t consider the impact of taxes on your investments you could lose a quarter or more of your yearly returns! Fortunately there are strategies that will help you minimize your taxes.

Tax Shelters

The US government wants you to invest for both your retirement and for your kid’s college expenses.   It have created special accounts for these purposes that give you tax breaks as an incentive.    The gotcha is that they also impose fees if you use the money for other purposes!  You probably have heard of at least some of these accounts- 401K, Roth IRA, 529 Plan, 403B, or SEP.  The exact rules differ from account to account but the purpose of all of them is to avoid or at least delay paying taxes.

Tax Efficiency

Not all investments are taxed equally, for example the gains on corporate bonds are taxed at the higher ordinary income rate while the gains of stocks are taxed at lower capital gains rates.  If you can’t put all of your investments into a tax sheltered account, then you want to put the tax inefficient investments in the tax sheltered account and the tax efficient investments outside of the tax sheltered account.  You may even choose an investment that has lower pre-tax return such as a municipal bond in order to get a better after tax return.

Cut Investment Costs to the Bone

Would you be willing to examine your mutual fund fees for a quarter of a million dollars?  Could it make that big a difference?    Say you invest $5000 per year in a mutual fund that returns 8% over 40 years with a 1% fee, how much would you have?  Over a million dollars ($1,093,898)- compound interest is a wonderful thing! However, if you could invest in a different mutual fund that returns 8% over 40 years but has a 0.25% fee then your total grows by 23% to $1,351,458.93. That’s a $257,560 increase for a 0.75% lower fee! Every penny paid in fees or transaction costs is money that isn’t going to grow for you.  In many area of life you get what you pay for, but in investing you get what you don’t pay for!

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