Archive for the ‘Compound Interest’ Category

Lessons of Compound Interest: Compounding Frequency

Monday, November 2nd, 2009

Yearly Really Beats Never!

You don’t get compound interest if you never reinvest, and the difference between never and yearly reinvestment is huge!  Increasing the reinvestment frequency is always a bit better but if you are already reinvesting monthly there just is not that much more to gain.

Don’t Forget!

You don’t want to forgo compounding because you forgot to reinvest- so why not look into automating the process?  Are you receiving dividend checks or are they going to a money market account?  How long does that money sit before you invest it?  Does it ever get reinvested at all?  There are automatic options called Dividend Reinvestment Programs (DRIP).  These programs re-invest the dividends as soon as they are paid out and usually do so with very low transaction costs.  It’s easy to sign up for a DRIP but the enrollment process varies between brokers.  For example E*Trade has an online form to enroll your stocks- while Ameritrade requires a call their customer service to enroll your stocks.
If you have a CD Banks are usually happy to automatically reinvest a CD into another CD of the same term. Just make sure that you know what time frame you could withdraw without a penalty.

Shopping Time

If you have to delay reinvestment a week or so won’t make much of a difference in your overall return- but higher rates of return will.   Take a bit of time to shop around for better alternatives.  The internet is a great resource for comparison shopping for investments.  I found a lot of sites by searching “compare CD interest rates”.  Keep in mind that as long as you are under the FDIC limits any FDIC insured bank is just as safe.
If you invest in ETFs or mutual funds it is a good idea to check that the fees haven’t changed or that there aren’t other lower cost alternatives.  Again all of this information is available on the internet- for example if you own a Vanguard EFT the prospectuses are available here.  I found that page searching “Vanguard Prospectus”

Lessons of Compound Interest:Interest Rates Matter!

Wednesday, October 21st, 2009

 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!

Lessons of Compound Interest: Time is money

Wednesday, October 14th, 2009

Time is a required ingredient to put compound interest to work for you.   Here is how you can maximize the time for your investments to grow:

Invest now

You need decades for compounding to really kick in.  Sadly, none of us are getting any younger so we better invest as much as we can today!  Say Bob starts working at 22 and invests $6000 each year.  If he earns 8% compounded quarterly until he is 65, his final total is $2,229,668.  If he starts investing just five years later his total drops by more than $750,000 to $1,475,485. Time really is money, with compound interest each $1 you invest today will be worth a lot more than if you waited even a few years to start.   So, consider what expenses could you reduce today for a better tomorrow?

Don’t cash out

If you cash out your retirement savings, you sacrifice a small fortune in future growth.    After 3 years of contributing $6000 each year to a retirement account Bob’s investments are worth $20,520.  If Bob cashes out to buy a car, how much will that cost him in retirement?  Would you believe almost half a million dollars!   That’s a pretty expensive car isn’t it!  Investing for just three years less with 8% return totals $1,741,897 which is $487,771 less.

Keep Investing!

Even if you didn’t start early enough, or you made the mistake of cashing out you could catch up by investing longer.  Bob could try work for another three years and retire at 68 to pay off that half a million dollar car!  I wouldn’t want to count on this option for retirement as health problems could make it impossible.  However, delaying collage a year or two isn’t the end of the world.  Even a few more years could make a big difference in your final investment total.

Delay Withdrawing

If you can’t invest more, your investments can continue growing as long as you don’t withdraw too much.   In fact when you are nearing retirement the growth on you investments should be much larger than your contributions!  If Bob’s health isn’t too good and he has to retire at 65 his investment is growing by almost $150,000 a year.   Adding an extra $6,000 won’t have much of an effect at this point.  If Bob can live very frugally and work part time for three years without contributing anything his total is $2,209,147.

You Need to Understand Compound Interest

Monday, October 12th, 2009

Why should you care?

If you want to be wealthy or even just retire in comfort then you need to understand compound interest.   There are three factors that determine your results -the amount of time you invest, interest rate you earn, and compounding frequency.  To make the right investment choices you should know the effects of each of these factors.  Of them all time is the most important factor.  After a year compound interest amounts to pocket change but after forty years it can amount to a fortune!  The interest rate is also critical, a one percent difference in the interest rate will make a big difference in your final totals.  Finally, there is the frequency of compounding- the quicker the better but there isn’t much difference compounding faster than monthly.

What is it?

Compound Interest is earning interest both the amount of money you invested and the interest you have already earned.   I am going to look at compound interest graphically- if you want to read about the mathematical details I recommend reading this detailed description from Dr Math.

Time (with compound interest) is money!

Time is the biggest factor with compound interest, take a look at this graph of $1000 earning a 10% return with no compounding vs compounding monthly over 20 years:years:

  • Time is a huge factor
    • After two years only $20 more
    • After twenty years it is $4328 more!
    • After thirty years the difference is $16,837

The start investing as soon as you can.  Compound interest will only help you if you invest long enough to make a difference!

Interest Rates Matter!

As you can see compounding is a good thing, and pretty dramatic with a 10% interest rate.  Suppose, you get a lower interest rate for twenty years,  how does that affect your the returns?:

  • 1% is a big difference!
    • 10% -> 9% is more than the original investment ($1318)
    • 10% -> 8% is more than 2X the original investment ($2401)
    • 10% -> 7% is more than 3X the original investment ($3289)

Compounding Frequency the Least Significant Factor

The final factor is how frequently the earned interest starts earning interest.  Let’s look at the example of 20 years with a 10 % interest rate again, but compound it with different frequencies:

  • More frequent is always better but the effect diminishes rapidly
  • Never to yearly is a big difference
    • More than 3X original investment($3,727)
  • Yearly to quarterly is much smaller but significant difference
    • Not quite half the original investment ($482)
  •  Quarterly to Monthly even smaller
    • About a tenth of the original investment ($118.5)
    • This is at about 99% of compounding instantly
  • Monthly to Weekly still smaller increase
    • May buy you a dinner ($46)

I hope you found that you learned something,  I plan to follow up with a post onpractical investment lessons soon.   Unclear about something, Liked it, hated it?   Leave a comment, just be thoughtful.