The Good, the Bad and the Ugly of Compounding

Let’s talk about compounding interest baby, let’s talk about red and green, all the good things and the bad things that may be, let’s talk about compounding interest. Okay, so Salt-n-Pepa admittedly had a much better concept when they wrote for record sales, but I would argue this might be as important a topic. Compounding Interest, the biggest miss in our education system today and one of the most misunderstood by the average person.

To explain compound interest, I like to start with simple interest. It’s easier, straight forward and set’s the stage for or it’s older, roided out big brother. I loan you $100 at 10% simple interest due monthly, yes I know I’m a jerk but let’s get past that for a quick second. At the end of the month assuming you did not repay it you now owe me the originally $100 plus $10 in interest. Now the next month you owe $110, but the interest is 10% simple, so you owe only another $10 from the $100 loan added to the $110 for a grand total of $120. Still with me? Good. Now, a year is 12 months, 10% of $100 is always going to be $10, so if we multiply 12 x $10 we get $120. Add that to our initial loan amount of $100 and the debt is now $220. Not bad if you’re the lender, not so cool if you are the borrower. That is simple interest. Take the % of the debt every period and add it to the principal plus already accrued interest.

Now, let’s get to 8th Wonder of the World, apocryphally credited to Albert Einstein, Compounding Interest. Same example, but let’s shake it up a little bit and start with $100 loan, 10% interest Compounding YEARLY, that’s important because I want to use round numbers. First year end you take 10% of $100 and find it’s still $10. You now owe $110 just like before, the next step is where the magic starts to happen. The next year it’s year end and time to figure out interest, this time it’s  10% like before, but instead of 10% of $100, it’s 10% of $110. That makes it $11, doesn’t seem so bad, it only went up $1. Okay, every year we are now taking 10% of the entire amount principal PLUS interest. In the name of sanity I will give you the amount of 12 years of compounding, ready? $314.

It tripled in that same time, still doesn’t sound like a lot does it? Well let’s look at the difference in return over 12 periods, 220% for simple interest, and 314% for compound interest. Still this example seems small. Let’s use some real money. Say you start with $10,000 and INVEST it at 10% interest per year and go for 20 years, simple interest nets you $30,000, well that’s not so good. However, investing that same $10,000 at 10% interest over 20 years Compounding that will net you $67,275….whoa that is over 2x the gain on the same money all by the virtue of compounding.

You may say, “Daddicus! This compounding is great, why am I not doing that?”, the answer is you likely are, but it’s a question of the rate of return or RORC. Heck, you can even figure it out easily in Microsoft Excel, simply type =FV and then ( and it will set you up with the steps to calculate this. It starts with rate which is simply the % of growth expressed as a decimal (10% becomes .1), then nper which is simply how many periods (months, years) you plan to compound for, next is pmt where you can add in additional payments you plan to make each nper or 0 if you plan to not add to it and just see the growth, next is pv or present value in other words how much money are you starting with (put a minus before the number for positive results, I know it’s weird), and the last is whether it compounds at the start or the end of period, but we don’t need to worry about that. So it will look like, =FV(rate,nper,pmt,[pv],[type]) or in this example =FV(.1,20,0,-10000,0).

This is wonderful news for Investing right? Well, a resounding yes and a resounding no as well. How many of us have student loan debt, mortgages, credit cards, car loans, personal loans, etc… These all work on compounding as well. If you look at the APR which is the rate you pay interest you will see that there is a lot of accruing interest on some and not as much on others. It’s why student loans and mortgages take so long to pay off, it’s why if you miss that one credit card payment and it vaults from 7% to 18% makes life so painful. It’s the bad and quite frankly often, ugly side of compounding interest. It’s also a big reason why financial coaches harp on paying off debt first as you work toward financial freedom and then only buy with cash. It’s a deep black hole. So let’s leave those behind, that’s the worst there is right? Yeah, sorry, not the case.

Let’s look at our investing styles. Some will say, I don’t want to deal with investing my own money, and give it to a financial advisor, park it in a mutual fund or ETF. I cover all of these extensively in other posts so I won’t go into it other than reminding you that you are paying between .25% ETFs to 2% to a financial advisor or even more with the hidden fees of mutual funds, then there is turnover rate which I’ll cover in a later post which can take you closer to .5% to 3%. That doesn’t sound TOO horrible right? Well, let’s look at what that does to our growth calculations. I’ll use 1% in fees and turnover as a middle ground. Your $67,275 just became $56,044.11, that’s just 1%, and that’s not the only cut into your returns. Wait, what, there’s more?!?

Yes, sadly, there is inflation to consider, well how bad is inflation? The benchmark the Federal Reserve who controls monetary policy and uses it to try and control inflation uses is 2%. We sometimes are better than that and they are keeping interest rates artificially low and achieved 1.4% in 2020. However, if you pay attention to what goes on in the economic news starting early this year, the Fed as they are known nearly lost control of inflation. This will become much more serious when we hit the coming market correction. It could sail past 2% higher, but we will use their benchmark as our figure. So, now we are using 1% to someone managing our money and 2% inflation so we are achieving 7% annually. Our $67,275 is now only $38,696.84, ouch town, population you.

At least we know we’ll always get that 7% right? Right?! Yeah…According to the average return for the S&P 500 since adopting 500 companies in 1957 through 2018 is roughly 8%, if you include the great year of 2019 it is 10%, now with the see-sawing going on I’ll give it 9%. Please remember that Modern Portfolio Theory and Efficient Market Hypothesis, this is the best that you can expect no matter who is managing your money. Therefore subtracting 3%, we have 6% return a year, $67,275 now is only $32,071.35. If you are using mutual funds and an advisor your % will most likely be far less. The worst part is that we don’t even see the inflation in the short run and only discover it when it cuts our spending power full in half over about a 20-year period. Surely there cannot be any more bad news, I’ll put my money in the S&P index take my 6% and hope like hell I win the lottery, wrong.

Your money is not growing at 6% per year because the market is not growing every year at 9%. Remember that correction I said is coming, well that’s not me that’s saying it, it’s pretty much all of the brightest minds on Wall Street and the economic forums that watch these things. The Schiller P/E which I won’t go into in this but tracks overall P/E of the market as a whole is at levels only seen before MASSIVE crashes in the economy. Just saying. Many of these brilliant people will tell you to be ready for a downturn of anywhere from 30% to 50%. Wow, that’s encouraging right? Yeah, not to me either.

Now, will your advisor, fund manager, computer sell at the top? I’d say it’s unlikely, will they sell when it’s on the way down? If you are using a human then the answer is undoubtedly, yes. They will try to jump out as soon as they realize how bad it is and lock in some nice losses for you. However, they might only lose 49% to the markets 50%, bonus time for them! Also, you just paid them 1% according to our previous figures to do it. Then it’s 50% overall to you. Here is where compounding hurts, after losing 50% of the value of your account, it will take 100% growth to get back to EVEN. What if that happens the year you retire and need to pull on that money…half is gone, retirement might be out of the picture.

Well, you say, how can I possibly prevent this? Well, remember no loss is a loss until you sell…that doesn’t hurt too much, but what if you learned enough about investing to recognize when companies are trading far above their value and stay away from them? What if you buy them at a 50% discount to the value of the company? What if you see the state of the market and the red flags we are warned about and ignore the FOMO (fear of missing out) of your peers who are making money in this constantly growing market. THEY say the economy is never going to drop again…that’s been said before with just as much belief and been wrong. You stay in cash until the market makes sense again. It could take a year or two but you lose almost nothing in the downturn and buy at the right times in your wonderful companies and only take the ride back up?

You control THESE things, it’s scary, emotions are a thing in the market, but you can move beyond these things if you are just willing to learn. People have done it, some multiple times. Another way to offset this is to demand a higher rate of return. It’s why my investing style’s MARR or minimum acceptable rate of return is 15%. It takes more work, but the upside is much better. I can’t ignore inflation so let’s say I only get 13%, then in 20 years I have $115,230.88 and that is the minimum acceptable. Will I get every call right? No. Will I win more than I lose, very likely. Will I only make 13% on each of these, honestly I will probably do better. None of this comes from me thinking I’m smarter than anyone else, or better, but by riding the coat tails of men and women who are smarter than me and being willing to put in the work to win instead of abdicating my control to someone who honestly will never care as much about me as I do.

Let’s finish this by talking about taxes and savings accounts. Going to and looking for the highest yield savings accounts, you will be lucky to get .5% APY (Annual Percentage Yield), that is .5%, not 5% a year. That doesn’t even keep up with inflation! Your money in your savings account is losing over 1% a year and that’s being generous it is more likely to be much closer to 2%. What other options are there, if you want to keep up with inflation only and not grow right now you might get a 10 year treasury or T-Bill that would put you in the ballpark. You won’t lose or lose a very little bit and get your money back in 10 years…not great.

Taxes, so let’s cover the basics, any stock held UNDER 1 year is taxed as short-term rate which is higher, any stocks held OVER 1 year are taxed at a long term rate which lower. I won’t put in %s because it deals with your tax brackets, and I have no experience as an accountant or tax advisor and won’t put my head for that. Let us just remember our advisors and fund managers are working on a quarterly basis and the typical holding time is 3 months…well you can deduce the rest. So, remember when you’re looking at returns there is the hidden specter of the IRS unless it’s in an IRA or other tax advantaged account. I will not go into those at this time.  Finally, the disclaimer.

I am not making any recommendations for any product, service, investment type or any financial advice. This is because I am not a CFA, CPA or licensed in any way. This is all a matter of opinion only meant to educate and entertain, and I have not reviewed your financial situation as your fiduciary, I will not ask for, nor take money from you to act as such. I am merely providing information obtained on open network sources that are generally available to the public and crafting it in a manner that makes sense to me. Please do not take financial advice from me, because quite frankly I CAN BE WRONG and Mrs. Rex will tell you I often am. However, please go out and do your own research, you may very well come to the same opinion that I have.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s